Competitive Advantage Period

1
Competitive Advantage Period Growth Rate
Analysis

• Chris Argyrople, CFA
• Concentric

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Competitive Advantage Period (CAP)

• Economic Theory suggests that companies cant
  earn Economic Rents
• Firms earnining ROIC gt WACC attract competition,
  driving down returns to WACC
• ROIC
• WACC
• CAP

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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 gt 20 Years
• Great Companies CAP gt 15 Years
• Most SP 500 Cos 5 Years lt CAP lt 10 Years

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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).

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Buffett Secret

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

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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

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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

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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

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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

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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

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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)

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Risk

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

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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

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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

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Valuation ShortRun vs LongRun
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Multiple EXPANSION
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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?

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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.

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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.

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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)

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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

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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

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Why Does DDM Break Down?

• Growth gt WACC
• No Dividends (ok, replace with Earnings)
• Sustainable Growth g ROE x Plowback
• ROE lt 0
• Cant forecast stages in multistage model

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Seven Sources of Growth

• Price
• Volume
• Mix
• Acquisitions
• Cost Cutting
• Reinvestment of Internally Gener. Cash
• External Cash Raised for projects where ROIC gt
  WACC

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Coca Cola Spreadsheet
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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

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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?