Every few years financial markets witness a new fad. In the 1990s we had dot com companies, then the 2000s witnessed fads in real estate and MBS. Now it’s new-age tech companies. Such fads always lead to overpricing of companies as the market feels that existing metrics and theories can’t explain them. Investors claim “This time it’s different”. It’s the job of academicians to bring investors and financial institutions back to earth but academicians also aim to become famous. So they come up with new theories and confine the complete firm analysis with just that. This leads to an incomplete understanding of the company.
Keep in mind that business fundamentals have always remained the same. Be it manufacturing, servicing or platform company. That is to grow and create a strong sustainable competitive advantage (MOAT). Fundamental analysis converts this into valuation of a firm. However, one theory or framework can’t explain the whole valuation of a company. Valuation is a puzzle and different frameworks are pieces that need to fit in their place. In this article, I have tried to do that.
A firm is valuable if it’s ROIC (Return on Invested Capital) is higher than the cost of capital.
Cost of capital represents the return stakeholders expect from the company). ROIC depicts the return given by the firm from its business operations. ROIC depends on sustainable competitive advantage (MOAT). So, ROIC > Cost of capital indicates the firm is creating economic value for stakeholders.
Let’s see how ROIC is connected with business strategy.
First we look at an external environment
This includes macro economy, industry structure, major players in ecosystem, industry demand, supply chain, rules and regulations.
Second, we dive into firm.
We start with vision and mission statement. They appear philosophical stuff but they define boundary of the firm (Propounded by Ronald Coase). It states why does a firm exist, what activities it will conduct itself and what it will buy from the market. A trade-off between transaction costs (Including market imperfections and search costs) vs management costs is considered in defining the boundary.
Then we assess the culture of a firm. You can follow Mintzberg’s model of organization and you can also use Hofestead’s cultural dimension. Although Hoefstead’s cultural dimension is for the country but it can be used to analyse even a company.
Next we move on to value chain analysis. It is used to look at different functions (R&D, production, distribution, after-sales service). To assess their strength you can look at the checklist given by Robinson and Pearce. Then look at the firm’s core competency (Given by CK Prahalad and Garry Hammel). It means what combination of resources and capabilities a firm has that are valuable, rare and costly to imitate by others but your organizations can exploit them (VRIO framework). After that, assess the functional strategy (Superior efficiency, innovation, quality or customer responsiveness). It will lead to generic strategy given by Michael Porter (Cost leadership, product differentiation, focus). All this will tell us about the firm’s strengths and weaknesses.
Now, its time for competition.
There are different competitive forces. Buyers, Sellers, new players, existing players and substitutes. Competitive advantage just over one force may not be enough. The cumulative interaction of all these forces determines business MOAT. Stronger the moat higher will be ROIC.
Interestingly, many equate just entry barriers with MOAT, but it is a necessary and not sufficient condition. Intense competition within an industry or buyers/sellers having high bargaining power will reduce your moat despite having entry barriers.
However, nothing is fixed as business is a war. Here, ROIC is the end game and creative destruction (By Schumpeter) is the biggest weapon. This war has a different kinds of players. Business leader, follower and new entrant. Along with other players in ecosystem.
Interaction with buyers and sellers depends on bargaining power. Look at who is price taker and who is price setter. Also, consider at the price elasticity of demand. This is determined by importance of the product, proportion of expenditure, time period and substitutes.
Business leader use defensive strategy to sustain moat. It will continue to develop new products, maintain better relations with customers and improve production processes to have a cost advantage. It needs to focus on increasing key strengths (High competency and strategically important). While also focusing on improving its key weakness (Low strength but strategically important). A leader would be a mature company unless the industry itself is new. Company’s ROIC will be above the cost of capital until it can successfully do this.
A follower will aggressively exploit the weakness of the leader and gain an advantage in those areas. It may include making new products/services, better relations with customers, suppliers etc. Its ROIC will increase if it can successfully execute this strategy.
New player will typically try to break entry barriers. Or it will try to change the industry structure, like doing all the things differently so that existing players won’t be able to grasp the shift in plates. Or it can look to enter a niche uncontested market where existing players haven’t penetrated. Basically, it will also follow the VRIO framework.
Considering the company’s life cycle is also very important. Companies at a young stage (New players or existing players in a new industry) will generally have lower ROIC as they would be at a loss. That’s because they have high fixed costs. Also, growing companies intensely spend on marketing and R&D. They are expensed even though their benefit is accrued for more than 1 year. This happens because something is considered an asset if the benefit from it can be reliably estimated and in these activities we can’t. Although for valuation purposes we reformulate financial statements and there are standard tools for capitalizing some activities like R&D.
Now, as companies mature we expect that fixed costs will get spread over larger revenues and they would start generating profits. This will only happen if they have actually done some creative destruction and they have got sustainable MOAT. Only then cash burning startups can have positive cashflows in future.
Many start-ups today are shaking as they lack sustainable MOAT but they face intense competition. That’s why their viability is questioned. Their nature of business is not a problem. It’s a lack of MOAT. Also, Venture capitalists should not invest just on the basis of technology. Technology is a commodity, anyone can use hence it doesn’t satisfy the VRIO test of sustainable competency. Current global uncertainty has accelerated the process of churning out. Once the dust will settle only a few winners will remain and they will have all the exploits.
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