Valuing Growth in "Franchise" Businesses
DCF valuations are unreliable due to speculative projections; a returns-based approach focuses on sustainable earnings, reinvestment, organic growth, and cash can be an alternative for franchise biz.
"There is a fundamental stupidity about discounted cash-flow valuations. Depending on what you plug into the equation, you can get widely disparate multiples. You are combining very good information, your estimate of near-term cash flow, with very bad information, your estimate of distant cash flow."
Bruce Greenwald
To start, this post will not provide a detailed explanation of how to value a franchise business like McDonald's.
It’s important to clarify that a franchise is not a specific business model I will discuss further here.
Rather, it is a concept.
If you are looking for a discounted cash flow (DCF) calculation for McDonald's, feel free to skip this post and continue with your day. However, I assure you that spending a few minutes reading this post will enhance your understanding of the power of the franchise concept, the idea of return, and the approach to valuing a franchise business.
I. Defining a "Franchise" Business
According to Bruce Greenwald, a "franchise" business is characterized by its ability to generate above-average returns on capital over an extended period, primarily due to its protection from competition. This protection stems from the presence of "moats", which are essentially barriers to entry that make it difficult for new competitors to enter the market and erode the incumbent's profitability.
There are several key elements that define a franchise business, as described by Greenwald:
Sustainable Competitive Advantages (Moats): Franchise businesses possess distinctive characteristics that provide a lasting edge over rivals. These advantages act as barriers to entry, discouraging competition and allowing the company to maintain pricing power and profitability over time.
Measurable Moats: Greenwald emphasizes that moats can be objectively measured by examining two key factors:
Minimum Viable Market Share: This refers to the smallest market share a new entrant would need to capture to achieve sufficient economies of scale to be profitable and compete effectively. Industries with high minimum viable market shares, such as the carbonated soft drink market, tend to have stronger moats because it is more difficult for new entrants to gain a foothold.
Share Stability (Customer Captivity): This metric measures how market share changes hands within an industry. Industries with high share stability, where customers tend to stick with existing providers, tend to have stronger moats. Greenwald provides the example of the carbonated soft drink market, where only about 0.1% to 0.2% of the market share changes hands annually, indicating strong customer captivity and a formidable moat.
Dominant Market Position: Greenwald highlights that a simple but effective indicator of a potential franchise business is its market share. Companies that hold a dominant position in their respective markets are more likely to possess the economies of scale and customer captivity needed to sustain a moat.
Sources of Customer Captivity: Greenwald identifies several factors that contribute to customer captivity and strengthen a franchise's moat:
Habit: Consumer habit can be a powerful source of stickiness for frequently purchased products. Customers may simply prefer the consistency and familiarity of an established brand, making them less likely to switch. He mentions (and probably this is the reason why Buffett loves Coca-Cola) Coca-Cola as an example of a company that benefits from habit-driven customer captivity.
Search Costs: For complex or high-value products, the costs associated with researching and evaluating alternatives can deter customers from switching providers, especially if they are satisfied with the incumbent's offering.
Switching Costs: Some products or services involve direct costs of switching to a new provider. These costs can range from financial penalties to the inconvenience of learning a new system or transferring data.
Proprietary Technology: Companies that develop and control unique technologies can establish a competitive advantage that is difficult for rivals to replicate, further enhancing their moats.
Greenwald recognizes that traditional value investing methods often struggle to accurately evaluate the worth of growth companies, particularly those with strong market positions. When investing, it’s essential to focus on achieving a fair return.
Historically, investors focused on specific market segments, making it essential to understand the value of their assets. Their earnings power value approach (which we have discussed; link is attached) provided a clearer framework for incorporating external information than outdated Discounted Cash Flow (DCF) models. However, this approach has never effectively addressed the issue of growth.
It’s important to note that you cannot accurately determine the value of a growth business through traditional valuation metrics. The potential value is often dependent on projections well into the future and is highly sensitive to changes in growth rates and the cost of capital, making accurate valuation extremely difficult, if not impossible.Â
However, you can address a critical question: If I purchase this company at today’s price, what kind of return can I expect? By minimizing costs at the point of entry, your expenses decrease, allowing you to take home a more substantial portion of your gains.
II. Components of Growth Return
The value of growth in specific businesses is often forecasted well into the future and is highly sensitive to changes in factors such as growth rates and the cost of capital. I've mentioned how discounted cash flow (DCF) can be "manipulated" using these two factors. Interestingly, around 50-70% of a company's value typically comes from the terminal value calculation, which remains somewhat of a "mystery" to current investors.
Consequently, instead of attempting to determine an exact intrinsic value, Greenwald advocates for a "returns-based" approach. This method focuses on the expected return for an investor purchasing a company at its current market price.
This essential approach for value investors assessing growth begins with calculating sustainable earnings divided by the price paid, which yields the earnings return. This is typically done within a standard earnings power framework, as outlined by Graham and Dodd. Greenwald then breaks down the potential returns from a growth company into several components that can be analyzed individually and then combined to provide a comprehensive overview.
To begin, it's important to establish a strong qualitative understanding of how growth creates value. In franchise businesses, there are four aspects of growth that generate value, which do not apply in competitive markets:
Earnings Return: This is the foundational element, calculated by dividing the company's sustainable earnings by its current market price. This provides a baseline return similar to a traditional earnings yield calculation.
Reinvestment Return: This element accounts for the portion of earnings retained by the company for reinvestment rather than distributed to shareholders. To assess this, Greenwald emphasizes the importance of analyzing management's capital allocation track record. Have they historically generated value through acquisitions, cost-reduction projects, or other investments? The effectiveness of their capital allocation decisions is represented by a "value creation factor", which quantifies how much value they've historically created per dollar reinvested.
For example, a company with a strong track record of successful investments might have a value creation factor of 2, meaning that they generate two dollars of value for every dollar reinvested. Conversely, a company that makes poor capital allocation decisions might have a value creation factor of 0.2, generating only 20 cents per dollar invested.
Here's how to calculate the reinvestment return according to Greenwald's method:
Identify the company's net income
Subtract dividends and share buybacks
Divide the result by net income
Reinvestment Rate = (Net Income - Dividends - Share Buybacks) / Net Income
Determine the change in NOPAT (Net Operating Profit After Tax) over a period
Divide by the change in invested capital over the same period, ROIIC = Change in NOPAT / Change in Invested Capital
Reinvestment Return = Reinvestment Rate × ROIIC
This calculation shows the expected return from the company's reinvested earnings. If the returns from reinvestment exceed the cost of capital, the company is creating value through reinvestment; otherwise, it is not.
Organic Growth Return: This component captures the value generated from organic growth in both sales and profit margins, often driven by factors like expanding into new markets or improving operational efficiency. To estimate this, Greenwald suggests looking at the company's historical growth rates, tempered by realistic long-term expectations. For example, while a company might have grown at 12% historically, sustainable long-term growth might be closer to 3-4% above GDP growth, perhaps with an additional 1-2% from margin improvement.
Cash Return: Cash return refers to the money that can be returned to claim holders (both bondholders and stockholders) from a company's current operations. It's essentially the profit the business earns after paying taxes, minus the investments the company makes. You can estimate the cash return you’ll get from this calculation:
Cash Return = NOPAT - Reinvestment, or
Cash Return = Dividends + Share Buybacks
III. Synthesizing the Components
Greenwald recommends comparing the calculated total return (earnings return + reinvestment return + organic growth return) to the returns offered by alternative investments. For instance, if the market offers a 6% return, a company with a projected return of 12% would have a significant margin of safety.
In order to achieve this, one must possess discipline and maintain a conservative perspective on growth. Greenwald stresses the need for discipline and conservative estimates when valuing growth. Overly optimistic growth assumptions can lead to inflated valuations and disappointing returns. He recommends starting with a conservative baseline, such as GDP growth, for organic growth projections.
Furthermore, it is essential to recognize that even the strongest moats eventually erode. Greenwald introduces the concept of a "fade rate" to account for this inevitable decline.
This rate, determined by estimating the "half-life" of the franchise, represents the annual decline in value attributable to the erosion of the company's competitive advantages. For example, if a franchise is estimated to have a 50-year half-life, the average annual fade rate would be around 1.4% (72 divided by 50), while a 20-year half-life would imply a 3.6% fade rate. This fade rate needs to be incorporated into the return calculation to ensure an adequate margin of safety.
Lastly, Greenwald advocates for a transparent valuation framework that facilitates easy sensitivity analysis. The linear nature of his growth return calculation allows investors to quickly assess the impact of changes in key assumptions, such as the cost of capital or organic growth rate. This approach encourages a more disciplined and less speculative approach to growth investing.