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

2. 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

3. 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

4. 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).

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

6. 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”

7. 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

8. 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

9. 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

10. 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

11. 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)

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

13. 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

14. 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

15. Valuation ShortRun vs LongRun

16. Multiple EXPANSION

17. 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?

18. 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.

19. 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.

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

21. 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

22. 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

23. 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

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

25. Coca Cola Spreadsheet

26. 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

27. 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?