Two-thirds of the market value of US companies is based on intangibles. Yet, the source of all this intangible market value is considered to be "a mere detail" in some stock pricing models. For example, intangible market value is not given even a passing mention in McKinsey & Co.'s widely read is Valuation (4th ed.) by Tim Koller, Marc Goedhart and David Vessels. And the internal costs of developing intangible assets are summarily dismissed by the rules of financial accounting:
Development costs for intangible assets can be capitalized only under the most stringent conditions (page 580).
Roughly speaking, this means that "intangibles" can enter a company's balance sheet as an asset only when the market price paid for an asset is greater than its book value. To understand this dilemma one needs to recognize the fundamental difference between market value and book value. The former is based on the price of the company's stock - to which investors' credit management for the creation of intangible market value. The latter is determined by the rules of financial accounting - which are unable to recognize the creation of intangible assets as a function of managerial decisions, unless they are acquired.
The purpose of this post is to take a first step in tracing the theoretical linkage between the decisions of management and the creation of intangible market value.
THE MISSING FACTORS MODEL
In my post on Air Express Carriers: Mr. Smith Goes to Holland I compared actual market shares with optimal shares as if a merger had been consummated between FedEx (NYSE: FDX) and TNT [AEX: TNT] in 2007. Theoretical maximum earnings market share occurs when the operating expense of one carrier are optimized relative to those in its peer group. The peer group in that analysis consisted of the Swiss carrier Kuhne+Nagel [SWX: KNIN]; United Parcel Service (NYSE: UPS); and DHL [XET: DPW].
I followed that post with one on Air Express Carriers and the Missing Factors Model. It takes a lot from my book Competing for Customers and Capital where I build the three "missing factors" into the stock valuation process. These factors are:
- Peer performance
- Intangible value creation
- Expense optimization
The following sections illustrate how to capture the effects of the three missing factors in a single metric. I call it Relative Earnings Productivity -- REP for short. While the methodology is generically applicable, here I reveal its specific use with air express carriers.
MARKET SHARE IS THE FULCRUM
Market share is the hook on which I hang the three missing factors listed above. One of the first questions you might ask about this approach is: Why use market share? The answer is commonsensical -- if unexpected. Market share is the fulcrum of a business strategy. It is the pivot point on which to leverage intangible value from operating expenses. In short, if you optimize operating expenses, you maximize earnings. It turns out a widely accepted market share model can be found in the marketing literature.
Thirty-five years ago David Bell, Ralph Keaney and John D. C. Little wrote a working paper on the Assumptions of a Market Share Theorem. That paper was published by MIT's Operations Research Center in May 1973. Two years later a revision titled A Market Share Theorem was published in the Journal of Marketing Research. In the ensuing years hundreds of papers were inspired by this work. Among the most recent and relevant to this post is Why is Five a Crowd in the Market Share Attraction Model: The Dynamic Stability of Competition by Professor Paul Farris of the Darden School at the University of Virginia and his co-authors. In order to explain why they selected the Market Share Attraction [MSA] model to study competitive market dynamics the authors point out several of its important features:
- The MSA model is logically consistent
- Market shares are bounded by zero and one
- Shares sum to one across all the firms
- Other models do not have this property
- The model derives from four simple axioms
- Its parameters can be estimated easily
- It's a better predictor than alternative models.
MSA often is expressed in words as an us/(us+them) model. Mathematically stated m = y/(y+f) where m is market share, y is our company's operating expenses and f is the sum of their (peer companies) expenses. Operating expenses include the costs of everyone and everything that might affect how customers and investors value the business. In the case of express air carriers these range from the costs of operating aircraft and delivery vehicles to research & development, advertising & promotion expenses as well as the salaries and benefits of all employees. The basic premise is this: Every line item in an air carrier's operating expenses has some impact - however small or large it may be -- on its intangible market value.
MAXIMUM EARNINGS MARKET SHARE
Maximum earnings occur when marginal operating costs just equal the marginal operating income of the next share point. This means earnings after operating expenses are maximized at some unknown market share. To find this unknown value you begin by expressing company earnings and operating expenses as a function of market share, take the first derivative of this function with respect to m, set this expression equal to zero and solve (Appendix A, page 251). The result is the following maximum earnings market share equation.
The numerator under the radical in this expression is the marginal cost and the denominator is marginal revenue of the unknown market share where earnings are maximized. That's the sweet spot in a business strategy. If a company's market share is greater than that sweet spot it throws money down the drain. If its share is less that the sweet spot it leaves money on the table. Note this assumes there is no change in the underlying capital structure of the firm.
Now plug the data from the combined 2007 income statements of FDX and TNT into this expression along with their three competitors. The result is the theoretical maximum earnings market share: 23.6% of the peer group's total revenues, or $216.8 billion USD. This translates into FDX+TNT sales revenues of $51.1.
The two entries represented by the green balloons need some explanation. First, an express carrier's gross margin is assumed to be 100% because the marginal operating cost per "package" is virtually zero. One cannot even assign the marginal cost of fuel to a single package.
Second, the operating efficiency ratio [OER] of the combined companies is better than average. The expected value of OER is exactly one. An OER of 0.95 means that FDX+TNT would have to spend just $0.95 on operating resources that cost an average competitor $1.00. Five cents doesn't seem like a heck of a lot until you multiply it by $132.7 billion and realize this represents a $6.6 billion in operating efficiencies. This accounts for over half the EBITD of $12.1 billion produce by maximizing earnings of the combined companies. See Mr. Smith Goes to Holland.
The maximum earnings market share equation for a merged FDX + TNT in 2007 is more easily visualized as marginal cost and earnings schedules it produces. The schedules in the following chart were produced by simulating the equation over a range from 15% to 30% share of peer group revenues. Marginal earnings and costs are charted on the vertical axis.
Maximum earnings of the merged companies occur in this chart where the (red) marginal cost schedule intersects the (green) marginal earnings schedules. This happens at $2.2 billion USD. The difference between actual and maximum earnings market where the schedules intersect is just 18 basis points. What does this have to do with the creation of intangible market value?
COMPETITIVE ADVANTAGE AND SHAREHOLDER VALUE
Alfred Rappaport understands the relationship between shareholder value and competitive strategy perhaps better than anyone. Here's what he said about this relationship in his classic book Creating Shareholder Value: A Guide for Managers and Investors:
It is … productivity that the stock market reacts to when pricing a company's shares. Embedded in all shares is an implied long-term forecast about a company's productivity - that is, its ability to create value in excess of the cost of producing it. When the stock market prices a company's shares according to a belief that the company will be able to create value over the long term, it is attributing [this belief] to the company's long-term productivity or, equivalently, a sustainable competitive advantage. In this way, productivity is the hinge on which both competitive advantage and shareholder value hang (Rappaport 1998, 69).
When management wrings the last drop of earnings out of each sales dollar they can do no better unless they change their business model -- or merge, which amounts to the same thing. The degree to which they achieve this goal is measured by relative earnings productivity. This is the ratio of actual earnings to maximum earnings scaled to zero when the two are equal.
The following chart shows what the relative earnings productivity of the leading air express carriers would have been in 2007 if FDX had merged with TNT in that year.
The vertical axis is relative earnings productivity. The combined FDX+TNT and its three peers appear on the horizontal axis. Since the merged carrier's actual and maximum earnings are virtually equal at $12.1 billion its REP is zero. Close behind is UPS with a relative earnings productivity of -4%. Trailing these leaders at some distance are DPW and KNIN with relative earnings productivity of -21% and -34% respectively.
WILL INVESTORS READ THE TEA LEAVES?
DPW's actual earnings in 2007 were $19.3 billion USD. The company's theoretical maximum earnings were $24.4 billion. That is, the company fell 21% short of its maximum potential earnings in 2007. KNIN's actual earnings in that same year were $5.3 billion compared with maximum potential earnings of $8.0 billion. This represented a 34% short fall. Will investors read my tea leaves and factor these earnings short-falls into each company's stock price? Look to the future for an answer to this question.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.