Equity Valuation and Portfolio Management

CHAPTER 3

A Franchise Factor Approach to Modeling P/E Orbits

Stanley Kogelman, Ph.D.

President and FounderDelft Strategic Advisors, LLC

Martin L. Leibowitz, Ph.D.

Managing DirectorMorgan Stanley & Co.

The standard dividend discount model (DDM) is still a commonly used equity valuation model. The DDM has the advantage of simplicity, intuitive appeal and broad generality, but these advantages often mute or disguise the extreme variations in growth expectations, return on equity and sustainable earnings that dramatically change valuations and move markets.¹

The DDM provided the starting point for the development of the franchise factor model (FFM) that is the subject of this chapter. This model is based on a body of work that began as a series of papers that later were consolidated into two books on franchise value.²

In contrast to the DDM, the FFM provides a window through which we can peer more deeply into how variations in equity prices of companies or markets reflects the interplay between (1) optimistic and pessimistic growth projections, (2) return expectations on existing and potential businesses, and (3) long-term stable earnings. We find that competitive market forces, like magnetic attractors, tend to drive the P/Es of even the most outstanding companies toward equilibrium levels that fall well below current P/Es.

For the FFM, as with all models, the mathematics may be correct but the underlying assumptions will drive the results. When a model yields extremely optimistic ...