Competitive Advantage Period & Growth Rate Analysis Chris Argyrople, CFA Concentric

Competitive Advantage Period (CAP) Economic Theory suggests that companies can’t earn “Economic Rents” Firms earnining ROIC > WACC attract competition, driving down returns to WACC ROIC WACC CAP

What CAP Means Managers try to maximize area under curve by moving out on both axes ! ROIC Higher Longer Returns CAP WACC Super Companies: CAP > 20 Years Great Companies: CAP > 15 Years Most S&P 500 Cos: 5 Years < CAP < 10 Years

Reality: CAP can be Very Long Economic Thoery does not reflect the reality of the stock market: CAP can be very large (Economic Theory states that it will be low).

Buffett Secret To Generate Excess Returns, Buy: Value Creating Firms (Creates EVA) Where CAP growing or stable

Calculating CAP Value = Value of Current Ops + Forward Plan NOPAT + Inv (ROIC - WACC) CAP WACC WACC (1 + WACC) Intrinsic Val / Share = (Value + Cash - Debt) Shares Inv = Incremental Annualized Investment Note: formula assumes “next year”

Using CAP Determine how much of value is growth (mgt must act if no value to forward plan) Analyst can plug for: ROIC, WACC, or CAP

Value Based Framework Value Creation Value Drivers Cash Flow EBITDA Margins Risk Cost of Capital Sustainab. of Returns Comp. Adv. Period EVA Measures: Magnitude & Sustainability of Returns

EVATM vs. FCF Model FCF Model Value = PV(FCF) + PV(terminal FCF) EVA Model Value = Capital + Cumul. PV of Future EVA ** 2 Models should produce same result ** Can project and discount EVA

Incremental Analysis Examine Incremental EVA (year-over-year) ROI on Incremental Capital = Delta EVA / Delta Invested Capital Note: 1) Like first derivative in Calculus. 2) Some value derived from changing returns on existing investments. 3) ROIC can fall while ROI Increm is Rising

Using EVA to Make Money Value Investing: Mean Reversion Momentum Investing: Improving ROIC Growth Investing: High ROIC, Sustainable Time / Accuracy TradeOff: Stern Stewart uses 164 potential adjustments, about 7 matter CSFB: LOOKING FOR CHANGE IN EVA, NOT ABSOLUTE (I DISAGREE)

Risk Best Risk Measure Debt / Total Capital (Market Values, not Book Values) Examine PVGO as % of Stock Price

CSFB Methodology Screen for Increasing ROIC or CAP Look at Volatility Look for companies where PVGO as a % of Stock price is zero: this is a free option on Value Creation

Thoughts on P/E Multiples Market Average is 20X right now It is quite easy to go from 15X to 20X A company trading at 10X likely has problems -- be careful It is also easy to go from 30X to 20X Thus, mean reversion is likely near the mean, ask tough questions away from the mean As always, analyze each case separately

Valuation ShortRun vs LongRun

Multiple EXPANSION

What is the Price of a Stock? Price = Dollars paid for the stock Earnings = what you relate the price to Thus, P/E ratio relates the price to the earnings stream purchased. Lower P/E is better, all else equal but, how do you compare P/Es with firms that have different growth rates?

PEG Ratio PEG Ratio = P/E / growth dimensionless Relates P/E to growth Financial Press talks about never paying a P/E higher than the underlying growth rate of a stock -- i.e. they recommend never paying more than 1 times the growth rate. I disagree with this strict interpretation, although I strongly agree with the intent.

PEG Ratio: Implementation What do you pay for a non-growth firm? Easy. Pay the current earnings divided by the cap rate (WACC). Thus, for a non-growth firm, pay no more than the inverse of the WACC. Conversely, what do you pay for a firm growing 100% per year? Do you pay a P/E of 100? No because the growth rate is likely to trend towards a lower mean.

What PEG do you pay?? Ke = 12% Growth Rate Press Realistically 0% zero 1 / Ke = 8 X 5% 5.0 5 + 1 / K OR 5 + 8 = 13 10% 10 10 + 8 = 18 X 15% 15 15 + 8 = 23 X 20% 20 20 + 8 = 28 X 25% 25 30 X (my limit)

How P/E relates to Growth Constant Growth DDM P = Theoretical Stock Price based on DDM D1 = next years Dividend P = D1 / ( k - g ) k = CAPM cost of capital = rf + B* ( E(rm) - rf ) E(r) = D1 / P0 + g g = growth rate = ROE x plowback ratio

How P/E relates to Growth E(r) = Divid. Yield + Divid. growth Price = PV(EPS) + PV(growth) = E1 / k + PV(growth) P / E = 1 / k + PV(growth) / E P = E *(1 - b) / (k - g) P/E = ( 1 - b ) / ( k - g ) p/e positively related to growth

Why Does DDM Break Down? Growth > WACC No Dividends (ok, replace with Earnings) Sustainable Growth g = ROE x Plowback ROE < 0 Can’t forecast stages in multistage model

Seven Sources of Growth Price Volume Mix Acquisitions Cost Cutting Reinvestment of Internally Gener. Cash External Cash Raised for projects where: ROIC > WACC

Coca Cola Spreadsheet

Coke Example -- one cent miss The Coke example clarifies why a stock crashes when the company misses EPS by a penny A one percent downward revision in the future growth estimate for the company drives the DDM stock valuation down from $84 to $56 Thus, THE PENNY MATTERS DUE TO THE REVISION IN THE GROWTH RATE

Coke, Oct 1998 New 1998E $1.46 (it was above $1.80 at one time). Stock now at $67 Where does it go from here?