cap - Equity Research Americas Industry: Foods January 14,...

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Equity Research— Americas Industry: Foods January 14, 1997 Michael Mauboussin 212/325-3108 FD0059 Paul Johnson* 212/407-0415 Competitive Advantage Period “CAP” The Neglected Value Driver
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Frontiers of Finance – 2 – In 1991, a Goldman Sachs limited partner, Barrie Wigmore, released a study that attempted to determine what factors drove the stock market ’s above-average re- turns in the decade of the 1980s. After carefully accounting for earnings growth, a full 38% of the shareholder value created in the 1980s remained unexplained. Dubbed the “X” factor, this mysterious driver of value left Wigmore and the Wall Street Journal 1 , which published a feature article on the study, at a loss. Given overwhelming evidence of well-functioning capital markets, it appears completely unsatisfactory to attribute such a large component of share price performance to some unidentifiable and seemingly inexplicable force 2 . Fortunately, we believe there is an answer to this problem. However, to understand the solution there must be a recognition that share prices are not set by capitalizing accounting-based earnings, which are at best flawed and at worst substantially misleading. It appears that this was precisely the paradigm under which both Mr. Wigmore and the Wall Street Journal were operating. The focus must be on the economic drivers of a business, which can be defined as cash flow (cash-in versus cash-out), risk (and appropriate demanded return) and what we have dubbed “competitive advantage period”— CAP— or how long returns above the cost of capital will be earned. CAP is also known as “value growth duration” 3 and “T” 4,5 in the economic literature. CAP is also similar in concept to “fade rate.” In this context, we believe Mr. Wigmore ’s “X” factor can be explained by the market ’s extension of expectations for above-cost-of-capital returns. As Mr. Wigmore ’s analysis suggests, the length and relative change of CAP can have a substantial impact on the value of a business and the market overall. For example, the revision in expectations of Corporate America ’s ability to generate returns above its cost of capital is a powerful indicator that investors believed that America was more competitive at the end of the 1980s than it was entering the decade. This conclusion was later supported by economic analysis. It should be noted that in a well-functioning capital market all assets, including bonds and real estate, are valued using similar economic parameters. In the case of bonds, for example, the coupon rate (or cash flow) is contractually set, as is the maturity. The bond price is set so that the expected return of the security is com- mensurate with its perceived risk. Likewise for most commercial real estate trans- actions 6 . At the end of the day, the process of investing returns to the analysis of
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This note was uploaded on 01/29/2012 for the course FIN 6000 taught by Professor Banko during the Fall '11 term at University of Florida.

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cap - Equity Research Americas Industry: Foods January 14,...

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