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My Quantitative Valuation Model – Part 1

March 10, 2010 by The Fallible Investor

I have spent a lot of time on this blog discussing a number of qualitative factors that I think are very important in determining the value of a business. In this post I will discuss how I ‘quantify’ the value of a business.

My quantitative valuation model is a basic ‘Economic Value Model’. I determine the ‘central case’ intrinsic value of a business based on my estimate of its future ROIC[1], and asset growth.[2] My model assumes a business can sustain this predicted ROIC, and asset growth, for five years. After five years, I assume the business’s predicted ROIC will slowly revert to my discount rate and that there will be no further profitable asset growth.[3] I discuss why I assumed this further below. But firstly I want to make some general points about my quantitative model.

How I limit the risks of forecasting, in my valuation model

Using a valuation model requires me to make predictions about a business’s future. The major risk with making such predictions is that I may value a business for far more than it is probably worth. I try to limit this risk by:

  1. Assuming the business’s ROIC, and asset growth, will never be higher than it has been historically; [4]
  2. Assuming that the business will only sustain its predicted ROIC, and asset growth, for five years; and,
  3. Most importantly, having a large ‘margin of safety’[5].

Despite the risks of using a valuation model, I think Damodaran is correct when he says:

“Those who disdain valuation models for their potential errors end up using far cruder approaches (such as comparing P/E ratios or applying EBIT multiples)… they choose to sweep the uncertainties (of valuation) under the rug and act as if they did not exist”.[6]

Why I do not use comparable market valuations

I do not value a business by using ‘comparable’ private or public market valuations because market sentiment can heavily influence these valuations.

Why my valuation model assumes that a business will only sustain a high ROIC for a maximum of five years before it slowly falls to my discount rate

I assume this because of competition and ‘reversion to the mean’.

My valuation model assumes that a business with both a sustainable competitive advantage and a high ROIC, will only sustain its high ROIC for a maximum of five years before it slowly falls to my discount rate.[7] I have assumed this because I could easily overestimate the strength and sustainability of a business’s competitive advantage. If I am wrong, and I do not make this assumption, I could dramatically overvalue the business.

I will discuss the more detailed issue of why my quantitative valuation model assumes a business will only have profitable asset growth for five years in my next post.

[1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit.

[2] These are determined on both quantitative and qualitative criteria.

[3] My valuation model is very similar to the one used by Deutsche Bank’s CROCI model. The good news is that Deutsche Bank’s research has shown that their CROCI based valuations closely approximate the market’s valuation of a business, over the medium term. This means that my valuation of a business is a good proxy for the price that the market will ultimately pay for a business. See P203, ‘Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.

[4] Except for the last year.

[5] For a detailed discussion of the concept of ‘Margin of Safety’ see: http://thefallibleinvestor.com/2010/02/17/my-investment-process-the-basics-part-2/

[6] Chapter 23 P 30, ‘Investment Valuation’, Aswath Damodaran.

[7] Many business’s with a high ROIC will have this return driven down to the average ROIC for a business in 5 years or less, see ‘Great 10-year Record = Great Future, Right’, Tweedy, Browne Company.

Posted in My Quantitative Valuation Model - 1 | 1 Comment »

The linkage between ROIC, Market Value, Replacement Value, and a Sustainable Competitive Advantage

March 3, 2010 by The Fallible Investor

I define the replacement value of a business as what the business’s assets would be worth if it’s ROIC was equal to its cost of capital.

The market value of a business with a high ROIC and no sustainable competitive advantage should (assuming the market eventually prices a business at its intrinsic value[1]) fall to its replacement value. This should happen because if an incumbent business has a high ROIC, and no sustainable competitive advantage, other businesses will enter this industry, or expand within the industry, to seek these higher returns. These competitors will drive down the incumbent business’s profits until its ROIC declines to the average return of a commodity business. Once this occurs, the incumbent business can only be worth the cost of replacing the business’s assets.

Professor Greenwald has another way of describing this process. He points out that if an incumbent business, with no competitive advantage, has a replacement value of $100 million and its market value is $200 million[2], competitors will drive its market value down to $100 million. Competitors will calculate that by spending $100 million to reproduce the assets of that business they can also create an enterprise with a market value higher than $100 million. These competitors will think, correctly, there is no reason for why they should have a different economic experience from the incumbent because there is nothing it can do that they cannot. Remember the incumbent business has no sustainable competitive advantage. Competitors, by reproducing the assets of the incumbent business, will increase the supply of products or services in the industry. There will now be more competition for the same business. Either prices will fall or, for differentiated products, each producer will sell fewer units. In both cases, the incumbent’s profits will decline and the market value of its business will decline with them. This process, capacity continuing to expand, and the profits and the market value of the incumbent’s business falling, will continue until the incumbent’s market value falls to the replacement value of its assets ($100 million). Its competitors will suffer the same fate.

Greenwald points out that while this process does not happen smoothly or automatically it will eventually turn out this way. It happens because the incentives for businesspeople to take advantage of the market’s excessive valuation of the incumbent’s business are too powerful.[3]

The market value of a business with a sustainable competitive advantage can, by contrast, stay much higher than its replacement value simply because it can sustain a high ROIC.

[1] The intrinsic value of a business is what I think the business is worth to a rational businessperson.

[2] Assuming the business has a high market value because it has a high ROIC.

[3] P38, ‘Value Investing: From Graham To Buffett And Beyond’, Bruce Greenwald et al, 2001.

Posted in Competitive Advantage - 3 | 3 Comments »

What factors are not a sustainable competitive advantage

March 1, 2010 by The Fallible Investor

As previously discussed, I want a business, which I have predicted will have a high ROIC, to have a sustainable competitive advantage. However, I think a sustainable competitive advantage is limited to a small number of competitive advantages.[1] I think it is very useful, when deciding whether a business has a sustainable competitive advantage, to understand what is not a sustainable competitive advantage.

Greenwald and Kahn in their seminal book, ‘Competition Demystified’, have outlined the following factors, which they think, and I agree, are not a sustainable competitive advantage. They think these factors will only temporarily allow a business to have a high ROIC.[2]

Having a cost advantage based on superior technology, which cannot be patented

A business with superior technology, which cannot be patented, does not have a sustainable competitive advantage. This is because the technology will usually be either rudimentary, which its competitors can easily reproduce,[3] or technology developed by specialist third parties (like Accenture or IBM), which is likely to be sold to its competitors.[4]

The inability to make this superior technology a sustainable competitive advantage is a major problem for businesses in the services sector.

Having a cost advantage based on lower labour costs

A business with lower labour costs (for example it uses cheap labour in China or India) does not have a sustainable competitive advantage because its competitors can, and usually will, source the same cheap labour.

Having a cost advantage based on lower capital costs

This usually means getting cheap capital from a Government. Having access to cheap capital from a Government is not a competitive advantage. It is a subsidy.

Having product differentiation

Product differentiation is not a sustainable competitive advantage because if a business has a high ROIC, due to product differentiation, competitors can, and will, enter that market and sell their own differentiated product. This will cause the business’s sales volume to fall and, because its fixed costs remain the same, the lower volume will mean its profit margin also falls. Its profit margin and sales volume will continue to fall until its high ROIC disappears.[5]

Having a strong brand

Having a strong brand is not a sustainable competitive advantage.[6] Brands are assets just like property, plant, and equipment. A business must spend cash to build or buy the brand, and cash each year to offset the depreciation of the brand. A competitor can easily spend its own cash to create a brand. If a competitor has an equal opportunity to create its own brand, the business with the brand has no competitive advantage. Brand investments are, thus, no different from many other investments: they return the cost of capital and do not provide any excess return to shareholders.[7]

Being the first mover in an industry

Being the first mover in an industry is not a sustainable competitive advantage. Being the first mover may give that business learning curve cost advantages. This means that as the business moves down the learning curve it becomes more efficient and can produce the product with lower variable costs than businesses just learning how to produce the product. However, as the industry matures, and its competitors learn to be efficient, this disadvantage usually disappears. The business may even find itself at a competitive disadvantage because it now suffers from vintage effects. That is it has less efficient plant and equipment than later entrants into the industry.

Being the latest entrant in an industry

Being the latest business to enter an industry and, therefore, usually having the latest technology or the ‘hottest’ product design will not give the business a sustainable competitive advantage because these advantages are, by their nature, only temporary. Moreover, once the business enters the industry it becomes an incumbent. The same advantages it enjoyed, when it first entered the industry, will now apply to any new entrant.

Having lower variable costs from new capital expenditure

A business (in a commodity industry) which reduces its variable costs by undertaking new capital expenditure has not created a sustainable competitive advantage because its competitors can easily do the same thing.  

Good operational efficiency

Good operational efficiency is usually only a temporary competitive advantage (there are exceptions). It is usually only temporary because this operational efficiency can naturally decline, or a competitor can reproduce it.

 A business’s good operational efficiency can naturally decline because:

  1. Management dies, or retires, or is poached by other businesses; or,
  2. Management becomes sidetracked by some major internal or external issue (for example they make a takeover offer, or are involved in a major lawsuit); or,
  3. Management simply loses its drive.

 A competitor can reproduce another business’s good operational efficiency by copying the successful business’s operational practices, or by recruiting better management.

[1] Economies of Scale combined with Customer Captivity; a Network Effect, a Government Licence; Patent Protection;  and, Customer Captivity.   

[2] See Chapter 2, ‘Competitive Advantages 1’ in ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[3] Rudimentary technology (simple products and simple processes) is hard to patent because this technology will often look like common sense. Thus, a business with this technology will often have its competitors duplicate the technology by hiring away its the employees.

[4] Technology developed by specialist third parties (such as Accenture and IBM) is likely to be sold to any business that wants to buy it. These third parties make their living by disseminating their innovations as widely as possible. See P 29, ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[5] Businesses which only rely on product differentiation must also be very efficient. Not only must they be very efficient with their production costs (which obviously applies to any business without a competitive advantage) but they must also be very efficient in those aspects of the business which allows it to differentiate its product (advertising, product development, service, distribution channels and a host of other functions). Inefficient businesses selling differentiated products will struggle to remain viable. See P23, ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[6] Greenwald and Kahn believe that while a brand is not a competitive advantage, it can lower the cost of entry into another market because the business may not have to build a brand from scratch. See ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[7] See P39, ‘Measuring the Moat, Assessing the Magnitude and Sustainability of Value Creation’, Michael Mauboussin, 16 December 2002.

Posted in Competitive Advantage - 2 | Leave a Comment »

What is a sustainable competitive advantage?

February 26, 2010 by The Fallible Investor

A sustainable competitive advantage is the ability for a business to do something that its (potential) rivals cannot. It means being able to:

  1. Keep the business’s current customers;[1] and,
  2. (Possibly) grow by attracting new customers;
  3. On terms which are more profitable than the business’s competitors;
  4. For a reasonably long-time (it is sustainable not temporary).

 I think the best competitive advantages in achieving this are, in descending order:

  1. Economies of Scale combined with Customer Captivity;
  2. A Network Effect;
  3. A Government Licence;
  4. Patent Protection; and,
  5. Customer Captivity.[2] [3]

How a business gets a competitive advantage

A business usually gets a competitive advantage from deliberately trying to gain a competitive advantage, or simply by good luck.[4]

Where do you find businesses with sustainable competitive advantages? 

I agree with Greenwald and Kahn’s conclusion that a business with a competitive advantage is much more likely to be ‘local’ and operate:

a)     In a limited geographical area (Wal-Mart in the US south); or,

b)     In a limited product space (Microsoft with its operating systems).[5] 

 This usually applies irrespective of the type of competitive advantage. For example, a business with an economies of scale competitive advantage is more likely to be ‘local’ for two reasons. Firstly, operating in a small market makes it is more difficult for a new entrant to capture enough market share off the incumbent to reach economies of scale. Secondly, high fixed costs, the linchpin of economies of scale, are fixed only within the region or product space in question.[6]

 A business with a customer captivity advantage is also more likely to be ‘local’ because it is often selling a customised product or service to its customers. Providing this customised product or service usually needs the business to specialise in a limited geographical area or product space.

 The restricted nature of a government licence or patent also means that businesses with these competitive advantages are often in a limited geographical area or product space.

A competitive advantage is limited to the product

If a business has a competitive advantage with a particular product that does not mean it has a competitive advantage with its other products. For example, Pepsi drinkers have no particular attachment to KFC.

I will discuss each of these different types of competitive advantage, and how strong I think they are, soon.

[1] Other than customers that naturally die or age out of the market.

[2] Customer captivity refers to how a business has ‘captured’ a customer. This can be because the customer will have high costs in ‘switching’ to an alternative product or an alternative service provider, or high costs in ‘searching’ for this alternative, or simply because the customer has developed a strong ‘habit’. I will discuss this form of competitive advantage in much greater detail in a later post.

[3] I think customer captivity is not as powerful as the other competitive advantages because it only allows a business to profitably grow from its current customer base. It does not allow the business to grow by attracting new customers on the same profitable terms.

[4] A business may have a competitive advantage simply because of good luck. As Denrell points out: “(it) is often argued that a strong performance record by a business cannot be because of good luck but indicates superior practices. The underlying idea is that sustained high performance is less likely to be the result of chance events. In other words, high performance during a number of years will filter out random noise and better reveal average tendencies, perhaps determined by capabilities. The reasoning assumes that the performance of an organisation is the sum of independent and random variables. If the random variables are not independent, high performance during the whole period may not be very impressive. An analogy makes the point. It a runner wins 10 independent races, she is probably a good runner. Suppose the races are dependent, however. That is, if a runner won by one minute, she starts one minute before the second runner in the next race. Clearly winning 10 such races is less impressive because if you won the first, you should have a higher chance of winning a second… Many industries consist of such dependent races.” See, P 295, ‘Should we be impressed with high performance, J. Denrell, Journal of Management Inquiry, September 2005.

[5] See ‘All Strategy Is Local’, Bruce Greenwald and Judd Kahn, Harvard Business Review, 2005.

[6] Ibid at P3.

Posted in Competitive Advantage - 1 | 4 Comments »

Why a business, which I have predicted will have a high ROIC, must have a sustainable competitive advantage

February 25, 2010 by The Fallible Investor

I think the main reasons for why a business can have a high return on invested capital (ROIC) [1] [2] are:

  1. The business has had good luck;
  2. The business has been more operationally efficient than its competitors[3];
  3. The business has a sustainable competitive advantage;
  4. The business has a temporary competitive advantage; 
  5. The business’s earnings are high because the industry or the economy is at a cyclical peak; or,
  6. The business is in a new industry and competitors have only started to enter the industry.

The problem is that most of these reasons are likely to be unsustainable. This is because:

  1. The business’s good luck can easily run out;
  2. Competitors can become more operationally efficient, or the business becomes less efficient[4];
  3. The business’s temporary competitive advantage disappears;
  4. The business’s earnings falls because the industry, or economic, cycle turns; or,
  5. Competitors enter the new industry.

This is why I want a business, which has a high ROIC, to have a sustainable competitive advantage.[5] I think is far more likely that a business will be able to sustain a high ROIC if the high ROIC is due to a sustainable competitive advantage and not because of one of these other reasons. If is far more likely because it will be unprofitable for other businesses to compete against them.[6]

I will discuss what I think is a sustainable competitive advantage in my next post.

[1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit. 

[2] A high ROIC is defined as a ROIC significantly above my discount rate.

[3] See, ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[4] I believe that most businesses with good operational efficiency only have a temporary competitive advantage (there are exceptions). I think it is usually only temporary because this operational efficiency can naturally decline, or a competitor can reproduce it.

 A business’s good operational efficiency can naturally decline because:

  1. Management dies, or retires, or is poached by other businesses; or,
  2. Management becomes sidetracked by some major internal or external issue (for example they make a takeover offer, or are involved in a major lawsuit); or,
  3. Management simply loses its drive.

 A competitor can reproduce another business’s good operational efficiency by copying the successful business’s operational practices, or by recruiting better management.

[5] However, the closer my valuation assumes a business’s ROIC is to my discount rate the less sustainable the business’s competitive advantage will need to be.

[6] However, as Greenwald and Kahn point out, if competitors are not rational and do enter, or expand within the industry, I must never assume that they will then realise their error and just as quickly exit the industry, or reduce capacity. These two processes are not symmetrical. Competitors with patient capital and an emotional commitment to the business may not exit the industry for a long time. Greenwald uses the analogy that it is much easier to buy kittens and puppies then to drown them later. This will impair the profitability of those businesses in the industry that have a sustainable competitive advantage for years. See P25, ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

Posted in ROIC and Competitive Advantage | Leave a Comment »

Why I value a business using its ROIC instead of its ROE

February 24, 2010 by The Fallible Investor

I value a business using its Return on Invested Capital (ROIC) [1] because this profitability measure is independent of the business’s capital structure (the proportion of debt and equity). [2] A business’s Return on Equity (ROE) is not. I think the valuation of a business should be independent of its capital structure because the business’s value rests on the earnings it makes on the assets it uses, not on how it finances those assets. 

For example, a business can increase its ROE by using debt to buy assets. This will most likely increase the risk for the business’s equity holders. Increasing a business’s ROE, by increasing its debt, does not necessarily make the business more valuable because the return required for the equity holders must be higher to compensate for this greater risk. By comparison, if a business increases its ROIC it is undeniably more valuable.[3]  

Costantini explains this much better than I do when he says:  

 “Clouded thinking over debt and equity, assets and liabilities, of which the heavy use the ROE ratio is a prime example, is ubiquitous…

Suppose that an investor wanted to buy a property for rental income. Surely, he would wish to visit the property a few times, assess the surroundings, the amenities, the neighbours. He would make up his mind about a likely rent, the amount by which he could increase it every year, and then decide on a price that would make this investment worthwhile. Next would come haggling with the seller, and finally he would arrange financing. It would never occur to him to do it any other way especially not in the reverse of our suggested order. That is because the main object of this property buyer is to assess the growth and return prospects of an economic object, which demands an investigation of the asset side of the balance sheet. To this end, there is no relevant information on the liability side. On the other hand, suppose that our investor now wanted to investigate the market value of an economic object. The asset side is now not so useful.” [4]  

   

 [1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit. 

 [2] Joel Greenblatt determines a business’s profitability by its return on tangible assets (ROTA). See, ‘The Little Book That Beats the Market’, Joel Greenblatt, 2005. I measure a business’s profitability by its return on invested capital (ROIC). I prefer this measure because it shows you the business’s earnings as a proportion of all the assets of the business. The ROTA shows you the business’s earnings as a proportion of only the tangible assets of the business. 

[3] On a sustainable basis. 

[4] P57, ‘Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.

Posted in ROIC versus ROE | 2 Comments »

How a business’s ROIC tells me if its earnings growth will be profitable

February 23, 2010 by The Fallible Investor

In my last post I said that if a business’s ROIC has been, or is, greater than my discount rate, I think the business is likely to be viable. I also said it means that any growth by the business is likely to be profitable for me. In this post I am going to explain why a business’s ROIC tells me if its earnings growth will be profitable.  

How a business grows its earnings

Earnings growth by a business normally needs the business to grow its assets (for example inventory, receivables, plant and equipment and intangibles). The business usually has to pay for most of these new assets by using new capital.[1] This new capital must come from either retained earnings or new capital raised from shareholders (that’s me if I am an investor) or new borrowings. The owners of this new capital will have to be paid a return for providing the capital.[2]  

How a business’s ROIC tells me if its earnings growth will be profitable

A business’s earnings growth will only be profitable to me if the business earns more on these new assets than the minimum return I need to provide the capital (my discount rate). For example, when a business’s ROIC is equal to my discount rate, asset growth by the business will have no value to me because the return the business will earn on the new capital will just equal the opportunity cost to me for letting the business use my capital. Thus, while the business has increased in size, simply because it has more assets, the net return to me is zero.

When a business’s ROIC is lower than my discount rate, asset growth by the business will actually destroy value for me. This is because the business earns less on the new assets than the opportunity cost to me for letting the business use my capital.

Only when a business’s ROIC is higher than my discount rate is asset growth by a business profitable to me. It will be profitable because the business earns more on the new assets than the opportunity cost to me for letting the business use my capital. As a shareholder, I will receive these additional earnings. I will receive these additional earnings directly, either by dividends, or indirectly, by the business increasing in value because it has retained all or part of these earnings.[3]  

This is a very important point for investors to understand. Many investors think earnings growth by a business is unambiguously good. It is not. In many cases earnings growth will reduce the business’s value.  

[1] Some of the asset growth will usually be funded by a growth in spontaneous liabilities. Spontaneous liabilities are liabilities such as accounts payable, wages payable, accrued expenses, and accrued taxes. 

[2] For an excellent discussion of this process see, ‘Value Investing: From Graham To Buffett And Beyond’, Bruce Greenwald et al, 2001.  

[3] For an excellent discussion of this issue see, ‘Value Investing: From Graham To Buffett And Beyond’, Bruce Greenwald et al, 2001.

Posted in Earnings Growth and Profitability | 4 Comments »

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