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Assessing the Magnitude and Sustainability of Value Creation

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Assessing the Magnitude and Sustainability of Value Creation 16 December 2002 Americas/United States Strategy Investment Strategy Equity Research Assessing the Magnitude and Sustainability of Value Creation Illustration by Sente Corporation. • Sustainable value creation is of prime interest to investors who seek to anticipate expectations revisions. research team • This report develops a systematic way to explain the factors behind a Michael J. Mauboussin company’s economic moat. 212 325 3108 [email protected] • We cover industry analysis, firm-specific analysis, and firm interaction. Kristen Bartholdson 212 325 2788 [email protected] Investors should assume that CSFB is seeking or will seek investment banking or other business from the covered companies. For important disclosure information regarding the Firm's ratings system, valuation methods and potential conflicts of interest, please visit the website at www.csfb.com/researchdisclosures or call +1 (877) 291-2683. Measuring the Moat 16 December 2002 Executive Summary • Sustainable value creation has two dimensions—how much economic profit a company earns and how long it can earn excess returns. Both are of prime interest to investors and corporate executives. • Sustainable value creation is rare. Competitive forces—including innovation—drive returns toward the cost of capital. Investors should be careful about how much they pay for future value creation. • Warren Buffett consistently emphasizes that he wants to buy businesses with prospects for sustainable value creation. He suggests that buying a business is like buying a castle surrounded by a moat—a moat that he wants to be deep and wide to fend off all competition. According to Buffett, economic moats are almost never stable; competitive forces assure that they’re either getting a little bit wider or a little bit narrower every day. This report seeks to develop a systematic way to explain the factors that determine a company’s moat. • Companies and investors use competitive strategy analysis for two very different purposes. Companies try to generate returns above the cost of capital, while investors try to anticipate revisions in expectations for financial performance that enable them to earn returns above their opportunity cost of capital. If a company’s share price already captures its prospects for sustainable value creation, investors should expect to earn a risk-adjusted market return. • Studies suggest that industry factors dictate about 10-20% of the variation of a firm’s economic profitability, and that firm-specific effects represent another 20-40%. So a firm’s strategic positioning has a significant influence on the long-term level of its economic profits. • Industry analysis is the appropriate place to start an investigation into sustainable value creation. We recommend getting a lay of the land—understanding the players, a review of profit pools, and industry stability—followed by a five-forces analysis and an assessment of the likelihood of disruptive technologies. • A clear understanding of how a company creates shareholder value is core to understanding sustainable value creation. We define three broad sources of added value: production advantages, consumer advantages, and external (i.e., government) advantages. • How firms interact with one another plays an important role in shaping sustainable value creation. We not only consider how companies interact with their competitors through game theory, but also how companies can co-evolve as complementors. • Brands do not confer competitive advantage in and of themselves. Brands only add value if they increase customer willingness to pay or if they reduce the cost to provide the good or service. • We provide a complete checklist of questions to guide the strategic analysis (see Appendix A). 2 Measuring the Moat 16 December 2002 Introduction Ideally, corporate managers try to allocate resources so as to generate attractive long- term returns on investment. Similarly, investors try to buy the stocks of companies that are likely to exceed embedded financial expectations. In both cases, sustainable value creation is of prime interest. What exactly is sustainable value creation? We can think of it across two dimensions. First is the magnitude of returns in excess of the cost of capital that a company can, or will, generate. Magnitude considers not only the return on investment but also how much a company can invest at an above-cost-of-capital rate. Corporate growth only creates value when a company generates returns on investment that exceed the cost of capital. The second dimension of sustainable value creation is how long a company can earn returns in excess of the cost of capital. This concept is also known as fade rate, 1 competitive advantage period (CAP), value growth duration, and T. Despite the unquestionable significance of this longevity dimension, researchers and investors give it scant attention. How does sustainable value creation differ from the more popular sustainable competitive advantage? A company must have two characteristics to claim that it has a competitive advantage. The first is that it must generate, or have an ability to generate, returns in excess of the cost of capital. Second, the company must earn a higher rate of 2 economic profit than the average of its competitors. As our focus is on sustainable value creation, we want to understand a company’s economic performance relative to the cost of capital, not relative to its competitors (although these are intimately linked, as we will see). If sustainable value creation is rare, then sustainable competitive advantage is even more rare, given that it requires a company to perform better than its peers. We can visualize sustainable value creation by looking at a company’s competitive life cycle. (See Exhibit 1.) Companies are generally in one of four phases (see Appendix B for a breakdown by industry): • Innovation. Young companies typically see sharp increases in return on investment and significant investment opportunities. This is a period of rising returns and heavy investment. • Fading returns. High returns attract competition, generally causing economic returns to gravitate toward the cost of capital. In this phase, companies still earn excess returns, but the return trajectory is down, not up. Investment needs also moderate. • Mature. In this phase, the product markets are in competitive equilibrium. As a result, companies here earn their cost of capital on average, but competition within the industry assures that aggregate returns are no higher. Investment needs continue to moderate. • Subpar. Competitive forces often drive returns below the cost of capital, requiring companies to restructure. These companies often improve returns by shedding assets, shifting their business model, reducing investment levels, or putting themselves up for sale. Alternatively, these companies can distribute their assets through a bankruptcy filing. 3 Measuring the Moat 16 December 2002 Exhibit 1: A Firm’s Competitive Life Cycle Increasing Returns Above-Average Average Below-Average & High Reinvestment but Fading Returns Returns Returns High Innovation Fading Returns Mature Needs Restructuring Discount Rate Economic (Required Return Rate of Return) Reinvestment Rates Source: CSFB estimates. One of the central themes of this analysis is that competition drives a company’s return on investment toward the opportunity cost of capital. This theme is based on microeconomic theory and is quite intuitive. It predicts that companies generating high economic returns will attract competitors willing to take a lesser, albeit still attractive, return which will drive down aggregate industry returns to the opportunity cost of capital. 3 Researchers have empirically documented this prediction. To achieve sustainable value creation, companies must defy the very powerful force of reversion to the mean. Recent research on the rate of mean reversion reveals a couple of important points. 4 First, the time that an average company can sustain excess returns is shrinking. This reduction in sustainable value creation reflects the greater pace of innovation and a shift in the composition of public companies (i.e., today there are more young public companies than 25 years ago). Second, reinvestment rates and the variability of 5 economic returns help explain the rate of fade. For example, a company that generates high returns while investing heavily signals an attractive opportunity to both existent and potential competitors. Success sows the seeds of competition. Why is sustainable value creation so important for investors? To start, investors pay for value creation. Exhibit 2 provides a very simple proxy for how much value creation investors have anticipated for the S&P 500 since 1980. We establish a baseline value by simply capitalizing the last four quarters of operating net income for the S&P 500 by 6 an estimate of the cost of equity capital. We attribute any value above and beyond this baseline value to future expected value creation. The exhibit shows that over one-third of the value of the S&P 500 reflects anticipated value creation, a ratio that has increased in recent decades. 4 Measuring the Moat 16 December 2002 Exhibit 2: Rolling Four-Quarter Anticipated Value Creation 70% 60% 50% 40% 30% 20% Anticipated Value Creation 10% 0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Source: Standard and Poor’s, Aswath Damodaran, CSFB estimates. More significant, sustained value creation
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