Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 33. The Franchise Factor Approach to Firm Valuation

MARTIN L. LEIBOWITZ, PhD

Managing Director, Morgan Stanley & Co. Inc.

STANLEY KOGELMAN

Chief Investment Officer, Summer Hill Inc. & Partner, Advanced Portfolio Management

Abstract: Global equity market indices and their component companies from time-to-time exhibit unanticipated, dramatic changes in direction. At first, we see years of steadily rising valuations where-in market "experts" contemplate new paradigms. During such periods, almost all news is interpreted positively. Suddenly, some small event leads to a dramatic change in sentiment and all news is interpreted negatively. To some extent, such sentiment shifts are related to changes in macroeconomic conditions but the extent of those shifts likely reflects reexamination and reinterpretation of assumptions underlying key valuation measures such as the price-to-earnings ratio (P/E). Although market practitioners focus on the P/E ratio, the academic literature treats the P/E dismissively. A careful theoretical analysis of the P/E can provide surprising insights into valuation drivers and how modest changes in assumptions can lead to dramatically different results.

Keywords: dividend discount model (DDM), franchise factor model (FFM), tangible value (TV), franchise value (FV), "hyperfranchise" firms, "antifranchise" firms, P/E orbits, franchise labor, Q-type competition

INTRODUCTION

The standard dividend discount model (DDM), first introduced by J. B. William (1938) in the ...