What is a company’s competitive advantage?
Management and valuation professionals need to have a detailed understanding of a company’s competitive advantage. This blog shows why; upcoming blogs will demonstrate why this is also the case for strategy, communication and forecasting professionals.
Competitive advantage and strategy are often used interchangeably and a wide variety of loose definitions exist. This causes unnecessary confusion and a lack of precision.
We define a company’s competitive advantage as: its ability to sustainably earn an excess return, i.e. to achieve a return on invested capital (ROIC) that is above its cost of capital (CoC). This makes economic sense as competition will inevitably crowd out excess returns unless a competitive advantage acts as an impediment.
We define a winning strategy as: a company’s ability to provide sustainable and superior customer value relative to the competition. It is often created by a company performing a series of unique activities, or activities performed differently, that are integrated together in a way that supports and magnifies the effect of each individual activity.
For a strategy to be effective it must positively impact some combination of a willingness to pay, costs, reinvestment and risk. In other words it must create a competitive advantage, which is observable as a ROIC that is above its CoC.
Why competitive advantage (ROIC > CoC) is core to valuation
The central role that competitive advantage plays in valuation can be illustrated using one well known perpetual cash flow valuation formula (Equation 1), which can be rearranged to express a company’s valuation in terms of invested capital (Equation 1a). For more details an excellent source is McKinsey’s book: “Valuation: Measuring and Managing the Value of Companies”.
Enterprise Value is the whole business (equity plus debt minus excess cash)
Simplifying Assumptions:
- The company has reached a steady state
- Return on new invested capital (RONIC) = ROIC
- Net Operating Profit Growth = ROIC x Reinvestment Rate (this binds growth to investment)
- Reinvestment Rate = Net Investment / Net Operating Profit
How a company’s competitive advantage impacts its valuation
The formulas above can be brought to life by looking at a company’s valuation depending on whether it operates with a competitive advantage, no competitive advantage or at a competitive disadvantage:
i. Competitive advantage: Return on Invested Capital > Cost of Capital
In this case it is obvious that the second term in Equation 1a is positive, hence the:
- Enterprise Value is above Invested Capital: even after assuming that all assets including intangibles are correctly valued at the cost of reproduction.
- Value of growth is positive: as the return from investments is above the cost of funding them. Hence the faster a company grows the more value it creates. However, new investments must be made in projects where the company has a competitive advantage.
ii. No Competitive Advantage: Return on Invested Capital = Cost of Capital
In this scenario the second term in Equation 1a is zero, hence the:
- Enterprise Value is equal to Invested Capital: again assuming that all assets including intangibles are correctly valued at the cost of reproduction.
- Value of growth is neutral: as the return from new investments equals the cost of funding them.
iii. Competitive Disadvantage: Return on Invested Capital < Cost of Capital
In this scenario the second term in Equation 1a is negative, hence the:
- Enterprise value is below Invested Capital: again assuming that all assets including intangibles are correctly valued.
- Value of growth is negative: as the return from investments is below the cost of funding them. Hence the more a company invests, the faster it grows, but the faster it destroys value.
Competitive advantage is like a “Moat”
Value investors, spearheaded by Warren Buffet, hunt for companies that have a durable competitive advantage and that can be purchased at enough of a discount to intrinsic value so as to provide a “margin of safety”.
In other words they look for companies that can maintain a ROIC above their CoC. Warren Buffett visualises this as a company being like a castle that is surrounded by an impenetrable “moat”.
Why competitive advantage is key to a robust valuation
A valuation that incorporates a detailed understanding of a company’s competitive advantage will be inherently robust as it is grounded in economic reality. Furthermore, the valuation will implicitly incorporate a company’s strategy and value chain as these are key drivers of its competitive advantage.
Additionally, using such an approach enables a company’s valuation to be built up incrementally. The first building block is the Asset Value, followed by the Earnings Power Value and finally the Value of Growth:
I. Asset Value: this forms the core and if a company is in a viable industry it should be valued at the reproduction cost of all assets including intangibles.
II. Earnings Power Value: this is the value based off long term cash flows that have been adjusted to reflect no growth and other items such as one off accounting charges and cyclical effects. If a company has a competitive advantage then this will be above the asset value, otherwise it will equal the asset value.
III. Value of Growth: this is the extra value created when a company can find investments with a ROIC above its CoC.
Unlike a traditional discount cash flow valuation, the above valuation method has the significant benefit of not mixing together relatively certain valuations (asset values) with very uncertain ones (the value of growth).
Columbia’s Business School Professor Bruce Greenwald does a brilliant job of describing the methodology and how it works in theory and practice in his book “Value Investing: From Graham to Buffett and Beyond”.
The Bad Part: assessing competitive advantage is difficult
Understanding a company’s competitive advantage is a craft that requires skill, expertise and experience.
Harvard Professor Michael Porter lays out a robust framework for understanding the underlying factors that drive industry and company competitive advantage in his book “Competitive Advantage: Techniques for Analysing Industries and competitors”.
Additionally, Credit Suisse’s Michael Mauboussin does an excellent job of laying out practical steps to determine and assess a company’s competitive advantage in his paper: “Measuring the Moat: Assessing the Magnitude and sustainability of Value Creation”.
We believe that an analysis of a company’s competitive advantage is best conducted using the tools and techniques from many disciplines such as: strategy, finance, management, competition, innovation, marketing, economics, behavioural economics etc.
However, far more importantly, Charlie Munger is a strong advocate of using a multidisciplinary approach when it comes to understanding a company’s competitive advantage and its underlying value. His rationale is captured very well in Tren Griffin’s book “Charlie Munger: The Complete Investor”.
In another blog we will take a look at how to assess a company’s competitive advantage.
Key takeaway
Management’s objective is to create long-term shareholder value.
A robust valuation that is underpinned by a company’s competitive advantage acts as a well signposted roadmap and provides detailed knowledge and insights that are necessary for strategic thinking, diagnosing problems and uncovering opportunities.
We believe that a valuation model built in the manner described above provides an excellent “framework” on which to test hypotheses, ideas, insights, identify which business to divest or acquire and how to position the company to maximise its underlying value.
By Hugh Page
MD Integrated Value Consulting (IVC)
- What IVC does: we help SME entrepreneurs and leaders build & exit a valuable business at a premium
- How IVC Does It: we demystify business strategy & valuation and help you work “on” the business using our Valuable Business Builder System©
