Competitive Advantage Period & Growth Rate Analysis

1. Competitive Advantage Period & Growth Rate Analysis Chris Argyrople, CFA Concentric

2. 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

3. 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

4. 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).

5. Buffett Secret • To Generate Excess Returns, Buy: • Value Creating Firms (Creates EVA) • Where CAP growing or stable

6. 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”

7. 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

8. 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

9. 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

10. 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

11. 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)

12. Risk Best Risk Measure • Debt / Total Capital (Market Values, not Book Values) • Examine PVGO as % of Stock Price

13. 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

14. 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

15. Valuation ShortRun vs LongRun

16. Multiple EXPANSION

17. 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?

18. 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.

19. 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.

20. 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)

21. 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

22. 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

23. 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

24. Seven Sources of Growth • Price • Volume • Mix • Acquisitions • Cost Cutting • Reinvestment of Internally Gener. Cash • External Cash Raised for projects where: ROIC > WACC

25. Coca Cola Spreadsheet

26. 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

27. 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?