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Competitive Advantage Period & Growth Rate Analysis

Chris Argyrople, CFA

Concentric

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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

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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 > 20 Years

Great Companies: CAP > 15 Years

Most S&P 500 Cos: 5 Years < CAP < 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

Valuation is Secondary

Years: 10 10 10 15 15 15 15 5 2EPS Growth: 15% 20% 25% 10% 10% 10% 10% 15% 50%Multiple Contraction: 50% 50% 50% 50% 25% 50% 0% 70% 55%

Starting P/E 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 Starting EPS 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 Starting Stock Price 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 Ending P/E 25.00 25.00 25.00 25.00 37.50 25.00 50.00 15.00 22.50 Ending EPS 2.02 3.10 4.66 2.09 2.09 2.09 2.09 1.01 1.13 Ending Stock Price 50.57 77.40 116.42 52.22 78.32 52.22 104.43 15.09 25.31

Compound Return 7.3% 12.0% 16.6% 5.0% 7.9% 5.0% 10.0% -9.6% 0.6%

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Multiple EXPANSION

Years: 5 4 3 2EPS Growth: 15% 20% 25% 30%Multiple Expansion: 50% 50% 50% 50%

Starting P/E 15.00 15.00 15.00 15.00 Starting EPS 0.50 0.50 0.50 0.50 Starting Stock Price 7.50 7.50 7.50 7.50 Ending P/E 22.50 22.50 22.50 22.50 Ending EPS 1.01 1.04 0.98 0.85 Ending Stock Price 22.63 23.33 21.97 19.01

Compound Return 24.7% 32.8% 43.1% 59.2%

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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 > WACC

• No Dividends (ok, replace with Earnings)

• Sustainable Growth g = ROE x Plowback

• ROE < 0

• Can’t 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 > WACC

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Coca Cola Spreadsheet

Coca Cola Example: DDM and Growth Rates

Stock Price 72 E/(k-g)= 1.68/.02 = 84.00$ 98E EPS 1.68 1.68/.03 = 56.00$

WACC 11% 1.68/.04 = 42.00$ Estimated Growth Rate 9%

Value of Current EPS 15.27 21% Try with 25% or 30% growthImplied Value of Growth 56.73 79%

72.00

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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?