Evaluating a Company's Future Prospects, Part I

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Includes: GE, HD, KO, UPS, WMT
by: Brian Gaudet

In a previous article I described how to compute a company’s sustainable earnings per share and use this along with the company’s long-term issuer credit rating to estimate the intrinsic value of the company’s shares. Sustainable earnings are a useful quantification of a company’s demonstrated earnings power, but what assurance do we have that the company’s earnings power will persist into the future? None really, as there are many forces external to a company that can cause its earnings power to diminish over time, at no fault of the company’s management (incompetent management being yet another cause of diminishing earnings power). A common cause of diminishing earnings power is competition. If a company does not have a competitive advantage, then when new entrants into the company’s industry increase supply and push down prices, the company must lower its prices, or risk losing market share. Similarly, the introduction of substitutes can reduce demand for a company’s product. Both scenarios will typically cause a reduction in a company’s earnings. Earnings are also impacted by the relative bargaining power of buyers and suppliers, and the intensity of industry competition.

So although our estimate of a company’s intrinsic value – in the absence of selection bias - is probably accurate on average, a company’s actual perfect foresight intrinsic value will vary considerably from our estimate, and will often be quite a bit lower (it will also often be quite a bit higher, but in that case, we probably won’t complain). We can compensate for this in a couple of ways. First of all, we can gain a margin of safety by purchasing a company’s shares at a significant discount to their intrinsic value. For example, if we only purchase the shares of a company that is trading at a ratio of intrinsic to market value of 1.5, then even if our estimate of the company’s intrinsic value is optimistic by 50%, we still end up purchasing the shares at a price equal to their perfect foresight intrinsic value, and obtain a real 5.5% rate of return (5.5% being our inflation-adjusted discount rate). Still, with the inherent uncertainty concerning a company’s future earnings power, and the fact that we introduce selection bias via non-random stock selection, how do we know that even this much margin of safety is adequate?

In order to gauge the likelihood that a company’s earnings power will persist into the future, I evaluate the company using three criteria. First I examine the company’s operating history in order to quantify the extent of a company’s demonstrated competitive advantage. Next I estimate the company’s future prospects by looking deeper into the source of a company’s competitive advantage, and analyze risks to the company’s competitive position. In this step, I also analyze the company’s industry, paying particular attention to the industry’s profitability and stability - profitability being important because company profitability is often limited by industry profitability and stability being important because a competitive advantage tends to be more persistent in stable industries. Finally, since even a company with a strong competitive advantage can be forced into bankruptcy if it misses an interest payment on debt, I also take a close look at the company’s financial strength. I then base my required margin of safety on how well a company scores on these three criteria. Let’s now take a look at the sources of a company’s competitive advantage.

Sources of Competitive Advantage:

There are three major sources of competitive advantage: differentiation, cost, and focus (From Michael Porter’s book, Competitive Advantage). For example, when a company produces a product that is perceived as superior to that of its competitors, it can charge a premium for the product without losing market share; this is differentiation. A company also possesses a competitive advantage if it can produce a product similar to that of competitors at a lower cost. Finally, a company can gain a competitive advantage by focusing on the needs of a customer that are not being met by less focused competitors; this takes the form of either cost focus or differentiation focus. To illustrate, the company might achieve a cost advantage by focusing on a narrow market, or create a differentiated product that does not exist because the total market for the new product was considered too small for less focused companies. Regardless of the type of competitive advantage, a company gains a competitive advantage by creating more value for the company’s customers than competitors, through either a better product or a similar product at a lower cost.

Differentiation:

Differentiation gives a company pricing power; even if competitors drop their price, a company with a differentiated product can often keep its price stable without losing market share. Now compare this to a company with a completely generic product that cannot be differentiated from its competitors; such a company will lose significant market share if a competitor drops its price unless it quickly follows suit. With this simple example, we can generalize what it takes to create a differentiated product. First, the company’s product must be recognizable from that of its competitors; clearly a cord of wood fails this test while a can of Coke passes. Beyond that, the product must be perceived as superior to its competitors. In the case of soft drinks, beer, cigarettes, or packaged food, it might simply taste better, whereas for an automobile, passenger jet, or power-generating turbine, the product might have a reputation for quality. A product can also be differentiated by the cost savings created for the company’s customers, an example being GE’s composite fan jet engines that allows Boeing (NYSE:BA) to create a more fuel-efficient aircraft, which in turn saves airlines money through increased fuel economy.

Although the competitive advantage imparted through differentiation can diminish with time, this rarely happens quickly. Let’s look at a delivery service such as UPS, which has built a reputation for delivering packages on time, anywhere in the world. Now even if a competitor (let's call it Deliveries R Us) can invest billions of dollars and quickly build a global package distribution network, which one would you choose if your job depended on it? Even if UPS charged more, you at least know you won’t get fired for using UPS, whereas if this upstart lost your package, the obvious question your boss might ask is “Why didn’t you use UPS?” This same argument holds for many other products and services whose performance can have a material impact on the operations of a business that uses them; it can take many years for a new entrant to earn a reputation for reliability.

A similar case can be built for brand persistence with consumer products. Once you have found a product you are happy with, you might not want to take the risk that another product at a lower price will be of the same quality. With more expensive items such as automobiles, the cost of purchasing a lemon is high, so you might limit your car shopping to trusted brands that either you have a long personal experience with, or where independent research indicates a high level of customer satisfaction. On the other hand, with other items such as your favorite brand of beer, research really can’t tell you if you will enjoy an alternative brand, and you probably don’t have the time to purchase a sample just to see if it is better. As a matter of fact, when you are in a hurry, you probably just grab your usual brand and move on, without even checking the price.

Of course, given enough time and effort, it is possible that a competitor will create a product with superior quality than that of a company you are analyzing. An example of this is Japanese automobile manufacturers. At one time, any product manufactured in Japan was considered to be of inferior quality, and most people would not dream of owning a Japanese automobile. However, over time, it became apparent that Japanese companies were proficient at manufacturing, and the quality of their automobiles were quite good; eventually, they were perceived as being of superior quality to their American counterparts. Of course this change in perception took several decades, but it did happen, and it became necessary for companies like General Motors to improve the quality of their cars to rebuild their brand, which they did over time. The key point is that over long time periods, the strength of a company’s competitive advantage can change, which is why I prefer to leave a company’s competitive advantage out of the intrinsic value calculation, but consider it in the purchase decision.

Cost:

If a company can produce and distribute its product at a lower cost than rivals, it can often gain market share while at the same time maintaining profitability similar to competitors. Lower production costs can be achieved in many ways, including investment in the continuous improvement of manufacturing productivity, outsourcing the production of components to a company that can do it cheaper, setting up manufacturing in a country with lower labor costs, and the automation of factories. Similarly, an efficient supply chain can decrease a business’s inventory, thereby increasing return on assets, while at the same time insuring that a factory is never short of raw materials and a store never runs out of any item. Supply chains can also be set up to minimize transportation costs by combining rail, shipping, and trucking in an optimal manner. Often, labor costs can differ substantially within the same country; a good example is Wal-Mart (NYSE:WMT) vs. unionized retailers. A company can build a strong brand on the basis of cost, a couple of examples being Wal-Mart and Home Depot (NYSE:HD).

In my next article, I will discuss the quantification of a company’s demonstrated competitive advantage. For some examples of analyzing a company’s competitive advantage, see the “Company Analysis Examples” page on my website.

Disclosure: I own shares of Coca-Cola (NYSE:KO). I do not own shares of GE, WMT, UPS, or HD.