Beyond Earnings

5QUANTIFYING THE VALUE AND RISK OF A COMPANY’S CAP

“In order to attain the impossible, one must attempt the absurd.”

—Cervantes

KEY LEARNING POINTS

• A company’s ability to create economic value for its stakeholders is intimately linked to building a sustainable competitive advantage for its products and services. When determining whether a company with superior profitability is a good investment, it is beneficial to know the length of the competitive advantage period (CAP) priced into the stock.
• A company’s competitive advantage has two dimensions: the magnitude of the competitive advantage, which is represented by the spread between the return on capital and cost of capital; and the sustainability of the competitive advantage or how long it is expected to last in years. The value driver corresponding to sustainability is the rate at which a company’s profitability is expected to fade. A remarkably elegant insight is that its inverse is the competitive advantage period (CAP).
• We show that a fade rate can be incorporated into a Fundamental Pricing Model for performing back‐of‐the‐envelope valuations and estimating terminal value in DCF analyses. The sensitivity of a company’s valuation to changes in the competitive advantage period can be readily quantified by valuing the company at different fade rates.
• The material risk in owning a high quality firm isn’t represented by how it co‐varies with the market, that is, the stock’s beta, but rather by any real or perceived changes ...