Competitive Advantage Period & Growth Rate Analysis
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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?