2. The competitive advantage period the price takes for granted

Level 3: Reverse valuation

The previous module solved for growth and margin. What is missing is the variable most people forget and that costs the most money to ignore: how long the price takes for granted that company's advantage will last. Because a business is not worth something for growing, but for growing while earning more than its money costs it, and that has an expiry date.

Why value is born only from the spread

A company creates value when the return it earns on the capital it invests exceeds the cost of that capital. That gap between the two figures is the spread. If a company earns 20% on invested capital and its cost of capital is 8%, every new euro it puts into the business creates value. If it earns 8% and its capital costs 8%, every new euro is neutral: the company gets bigger and the shareholder is no better off. And if it earns 6%, growing destroys value with enthusiasm.

From this comes the most counter-intuitive consequence of the whole level: growth is neither good nor bad in itself. It is only good multiplied by a positive spread. Damodaran has been insisting on this for decades, and Greenwald takes it onto competitive ground: without barriers to entry the spread closes, because extraordinary profits attract imitators until they stop being extraordinary.

What the implied competitive advantage period is

If the spread closes sooner or later, then there is a number of years beyond which the company stops creating value even though it carries on operating. That number is the competitive advantage period (CAP). Nobody knows it. But the price is assuming one, like it or not, and it can be solved for exactly as growth was.

The idea is simple: if you know what the company is worth assuming its advantage lasts zero years, and you know how much value each additional year of advantage adds, you can ask how many years you have to add to reach the price on the screen. Mauboussin popularized this reading, and its virtue is that it turns an abstract multiple into something you can hold a considered opinion about: duration.

How to estimate it by hand

You need four numbers and one division:

• The no-growth value, which you already know: after-tax operating profit divided by the cost of capital. It is what the company is worth if it never creates value again.
• The annual investment the company makes in order to grow.
• The return on that investment, which decides how much it is worth.
• The cost of capital, which does two jobs: capitalizing the cash flows and discounting the distant years.

With that you work out the value created by each year of investment, and then you add years, discounted, until the no-growth value plus the accumulated years matches the price. The number of years you get to is the implied period.

A worked case: the ladder of years

A teaching example with rounded figures. A company has 10,000 million of invested capital and earns 2,000 million of after-tax operating profit: a return of 20%. Its cost of capital is 8%. Each year it invests a further 1,000 million.

The no-growth value is 2,000 divided by 0.08, that is 25,000 million. Now, each annual investment of 1,000 million returns 20%, that is 200 million a year in perpetuity, which capitalized at 8% is worth 2,500 million. Take off the 1,000 invested and each year of advantage creates 1,500 million of value.

They still have to be discounted, because the value created in year seven arrives seven years late. Adding up and discounting at 8%, the ladder comes out like this, and it is worth reading slowly:

• With three years of advantage some 3,900 million accumulate: implied price, around 28,900 million.
• With five years, some 6,000 million: a price of around 31,000 million.
• With ten years, some 10,100 million: a price of around 35,100 million.
• With fifteen years, some 12,800 million: a price of around 37,800 million.
• With twenty-one years, some 15,000 million: a price of around 40,000 million.

Notice two things. First, that the years are not worth the same: going from three to five years adds 2,100 million, whereas going from fifteen to twenty-one adds only 2,200 despite being three times as long. Discounting flattens the end of the ladder. Second, that a price of 40,000 million is not 60% more expensive than one of 25,000 in the ordinary sense: it is paying for twenty-one consecutive years of competitive superiority against none at all.

What fifteen years means and what three means

An implied period of three years says the market is granting barely any advantage: it believes competition closes the gap almost immediately. It is a price that breaks to the upside fairly easily, because the company only has to hold out a little longer than expected.

Fifteen years says the opposite: the price takes for granted that the company will defend its position for a decade and a half against everyone who wants in. It can happen, and it has happened. But the burden of proof lies with the buyer, and the right question is a specific one: exactly which barrier stops the spread closing in year seven?

What the number does not tell you

Three cautions before you use it. The first: it is an approximate and sensitive number. Moving the cost of capital from 8% to 9% throws the implied period out completely: with the figures in the example, at 7% some eight years would be enough, and at 9% no number of years ever justifies the 40,000 million. The second: in reality the spread does not collapse all at once, it narrows little by little, and that gradual fade lengthens the nominal number of years without changing the underlying demand. The third: a short implied period does not mean buy and a long one does not mean sell. It means the price is asking for little or asking for a lot, and what to do with that information is another conversation.