These Notes Are A Synthesis of Ideas Presented in The Following Books

These notes are a synthesis of ideas presented in the following books:
“Quality Investing: Owning the best companies for the long-term” by Torkell T. Eide, Lawrence A. Cunningham
“Corporate Valuation Theory, Evidence and Practice” by Holthausen and Zmijewski
“Valuation: Measuring and Managing the Value of Companies, 5th Edition” by Tim Koller, David Wessels, Marc Goedhart,
McKinsey & Company
I created this document primarily thinking about incoming analysts and students preparing for finance and consulting
interviews. Being able to think systematically about companies and their competitive advantage is important both in public
and private investing, as well as in management consulting.
I hope that you will find these notes insightful. If you have any comments, feedback or just want to connect, feel free to
email me at michal.m.kolakowski@gmail.com.
Developing an Investment Thesis
GENERALIZED FORMULA OF A SUCCESSFUL COMPANY
ASSESSING THE COMPETITIVE ADVANTAGE
ALLOCATING CAPITAL TO DRIVE VALUE
UNDERSTANDING GROWTH
LINKING REVENUE GROWTH AND CAPITAL ALLOCATION
ANALYZING PATTERNS OF SUCCESSFUL COMPANIES
By Michal Kolakowski – June 2020 1

GENERALIZED FORMULA OF A SUCCESSFUL COMPANY
Company creates value by investing capital raised from its investors to generate future cash flows at the rate of return
exceeding its cost of capital, which is the rate investors require to be paid for the use of their capital. Any action
undertaken by the company which does not increase future cash flows to the firm does not create value.1
A successful company can be distinguished by its ability to deploy incremental capital at a high rate of return. This idea is
built on the compounded interest principle, one of the most powerful concepts in finance and economics, which
assumes that the interest in the next period (in this case free cash flow) is earned on the principal and previously
accumulated interest (in this example the existing equity).2
A successful company is a one which creates a virtuous cash generation cycle through: 3
(1) Generation of strong, predictable cash flows (FCF)
(2) Ability to reinvest these cash flows and sustain high return on capital (ROIC)
(3) Deployment of the incremental capital in attractive revenue growth opportunities (market size and growth)
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑔𝑒𝑛𝑒𝑟𝑎𝑡𝑖𝑜𝑛 (𝐹𝐶𝐹) × 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝑅𝑂𝐼𝐶) × 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐺𝑟𝑜𝑤𝑡ℎ 𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑖𝑒𝑠
Revenue growth and ROIC drive all company’s future cash flows, which then discounted by the cost of capital equal to
the value of the company. However, a company can only sustain strong revenue growth and high returns on
invested capital if it has a well-defined competitive advantage.4
ASSESSING THE COMPETITIVE ADVANTAGE
Competitive advantage is a characteristic which enables a company to outperform its peers. It can stem from either (1)
price premium advantages (differentiation), (2) cost and capital efficiency (cost leadership), or (3) a mix of both.
General observations: 5
(1) Competitive advantage is usually enjoyed by a particular business unit or a product line, not by the entire company.
Within a company individual businesses and product lines can have different degrees of competitive advantage and
thus earn different ROICs.
(2) Price premiums are harder to achieve than cost efficiencies, but are more attractive for achieving a high ROIC.
(3) In commodity markets companies are price takers, therefore, they usually compete through a cost leadership strategy.
(4) Most impressive businesses usually have several competitive advantages.
Sources of competitive advantage:

Price premium advantages (Differentiation) Cost and capital efficiency (Cost leadership)
Product innovation Efficient process
Brand Benefits of scale: Scalable product/process
Quality Benefits of scale: Economies of scale and scope
Customer lock-in Benefits of scale: Distribution advantages
Network effects Unique resources
Rational price discipline
1 Tim Koller, David Wessels, Marc Goedhart, McKinsey & Company, Valuation: Measuring and Managing the Value of Companies, 5th
Edition, (John Wiley & Sons, Inc. Hoboken, New Jersey), Part One, Chapter 1
2 Torkell T. Eide, Patrick Hargreaves and Lawrence A. Cunningham, Quality Investing: Owning the Best Companies for the Long Term,
(Petersfield, Harriman House, 2015), Chapter 1, Multiple Sources of Growth
3 Ibid.
Edition, (John Wiley & Sons, Inc. Hoboken, New Jersey), Part One, Chapter 1
5 Ibid., Chapter 4

Price Premium Advantages6 to sell a product at a premium the company needs to differentiate itself
(1) Product innovation
Products which are: protected by a patent (e.g. in pharma drug prices collapse by 80-90% when a patent
expires), difficult to copy (e.g. Apple iPods have a unique design and interface) or both, yield high returns.
Without a patent or copy-proof protections, even an innovative product won’t generate high returns (e.g. in
mobile phone handsets it usually takes one or two quarters to copy an attractive innovation).
Product offering superior benefits to the customers should yield above-average economic returns, but having
just one product is usually insufficient to sustain a competitive advantage.
Technology remains a challenging edge to sustain (e.g. Kodak, Polaroid).
(2) Brand
There is a very high correlation between quality and brand (e.g. Coca Cola, Perrier, Lacoste, Mercedes).
Often packaged food and durable consumers goods enjoy brand premiums, but it differs across product
categories (e.g. cereals like Kellogg sell at a premium, while meat brands don’t).
(3) Quality
Consumers are willing to pay a higher premium for a real or perceived difference between one product or
a service and another.
o Real difference: BMW cars have better handling thus earn a premium.
o Perceived difference: Till 2009 Japanese cars sold at a $2,000-3,000 premium to American cars even
though there were no substantial technical differences between vehicles.
The differentiation does not have to come from a product, but may come from superior servicing of a
product, speed of delivery or packaging.
(4) Customer lock-in
Due to high switching costs (it is costly for customers to replace one company’s product or service with
another’s), it is possible to charge a premium either at initial sale or in subsequent generations/iterations.
E.g. Bloomberg terminals.
(5) Rational price discipline
In commodity industries with many competitors, the law of supply and demand drives prices and ROIC
down (e.g. chemicals, paper, but also commoditized products/services such as airline seats).
However, if one competitor acts as the leader and others quickly replicate its price moves, it is
possible to sustain a rational, legitimate price premium.
i. Two conditions need to be met:
1. High barriers to entry;
2. Each competitor must be large enough that a price war would reduce profits on existing
volume more than any extra profit gained from new sales.
Most attempts by industry players to maintain a price floor fail (e.g. in paper industry all companies tend to
expand all at once.) When a lot of new capacity is added, then oversupply drives prices down.
There is also a free-rider issue (e.g. OPEC).
(6) Network effects7
Occurs when the system’s value increases as more people use it (e.g. Venmo, Airbnb).
Extremely efficient network can produce monopoly power and create a government intervention risk (e.g.
Facebook, Google).
E.g. social media sites, auction sites, ad forums, stock exchanges, search engines, online housing portals.
Cost and Capital Efficiency Advantages8 in practice cost and capital efficiencies tend to have common drivers
Cost efficiency is an ability to sell products and services at a lower cost than the competition.
Capital efficiency is an ability to sell more products per dollar of invested capital than competitors.
(1) Efficient process
Combination of production, logistics and pattern of interaction with customers, which results in a
cheaper way of delivering products that can’t be easily replicated.
Edition, (John Wiley & Sons, Inc. Hoboken, New Jersey), Part One, Chapter 4 and 5
(Petersfield, Harriman House, 2015), Chapter 1, Competitive Advantage

Most production methods can be copied, but some are harder to copy than others (e.g. Dell delivered PCs directly
to consumers, made machines to order with standardized parts and received payments from customers as soon
as the product shipped. On the other hand HP was producing in large batches and selling through retailers. It
was much harder for them to switch).
Company culture may play a significant role. For e.g. if the employee and management incentives target cost
control, the company may lower its overhead and optimize advertising/R&D spending.
(2) Benefits of scale: Scalable product/process
Having a product or a process that is scalable means that the cost of supplying or serving additional
customers is very low. It is usually achieved through leveraging IT systems (for e.g. ADP Inc. provides payroll
processing to small and medium enterprises, adding additional customers involves a negligible cost).
Margins of a scalable business increase as business grows (e.g. eBay, Microsoft, company that distributes movies).
Not all IT-based or IT-enabled businesses are scalable, many incur costs to service more similar to
consulting services. In these types of businesses costs grow with the number of clients, for e.g. data centers
work on cost-plus basis by adding people or equipment and facilities as they add new clients.
(3) Benefits of scale: Economies of scale and scope
Economies of scale: high fixed and variable costs spread over a large number of units produced.
Economies of scope: production of one good reduces the cost of producing another related good.
Relative size matters more than absolute size. There are benefits of costs spread over a large base.
Economies of scale are often misunderstood, since people think that they are automatic economies that
come with size.
They are achieved usually at a regional/local scale, not national or global (for e.g. for a retailer it is better to
be in one city than across the nation because of warehousing and local advertising costs).
Economies of scale can grant negotiating power. However, to have that power it is better to have number 1
market share in 10 states than number 1 market share nationwide, but only number 4 in every state.
Company gets benefits of scale only if the required investment in scale is large enough to deter
competition (e.g. UPS or FedEx already incurred huge fixed costs of building the national network).
Size and scale can work against a business as well (e.g. in 1980s UPS was outperformed by RPS in delivery service
to commercial customers by offering discounts. RPS was picking off high-margin businesses from UPS and
UPS’s scale did little to prevent it. What matters is having the right scale in the right market.)
Most successful players dominate industries with high minimum efficient scale relative to the market size.
(4) Benefits of scale: Distribution advantages
Competitive advantage in distribution network means that the company’s route to consumer is more
efficient than that of its rivals.
For manufactures who distribute their products through middlemen relationships are critical. Often these
relationships provide a significant layer of protection for manufacturers.
The situation is different when dealing with large chains where procurement is more rational. Large retailers
know their size and value to the manufacturers, therefore, they will bargain and pit manufacturers against each
other. Exceptionally strong product offering matters greatly.
However, distribution can also be a burden. Service networks encounter a chicken-and-egg problem.
Customers don’t buy the product/service unless they know it will be serviced. Yet when there aren’t many
customers and the utilization is low, the cost of operating the service networks is very high.
(5) Unique resources
Unique resources that cannot be replicated is a powerful cost advantage (e.g. a mine whose ore is richer than
most other ore bodies. The content of precious metals in Norilsk’s nickel ore is significantly higher than in Vale,
as a result Norilsk earned a 67% ROIC vs. 25% by Vale).
Geography often plays a role in gaining an advantage from unique resources.
In general, whenever the cost of shipping a product is high relative to the value of the product, such as cement
or salt, then producers near their customers have a unique advantage.
Companies usually pursue several competitive advantage strategies, though they tend to select one primary. For
e.g. McDonald’s, which focuses on cost leadership as its leading strategy, also attempts to differentiate its products to
some degree. On one hand they have a limited, fixed, standardized menu (cost leadership), but they still differentiate
themselves through branding and innovative product offering, like Happy Meals with toys.
To achieve a competitive advantage, companies need to develop specific capabilities. It is important to remember
that revenue and costs are always interconnected. A company which has a superior brand probably invests heavily in

marketing, which results in a higher SG&A cost and thus decreases profits. Conversely, a company which has a very tight
cost control on their operations may produce a lower quality good or provide a worse customer service, which will result
in a lower price premium and therefore lower profits. Most successful companies are able to manage well the trade-offs
between achieving price premiums and optimizing costs.
Examples of capabilities needed to pursue a differentiation strategy9:

Advertising and branding (e.g. Nike);
R&D and product design;
Engineering skills (e.g. BMW);
Service and distribution networks.
Examples of capabilities needed to pursue a cost leadership strategy10:

Design of efficient processes of production;
Ability to create technologies for efficient production;
Tight cost control on operations;
Reporting system that quickly alerts managers if either the production process or spending gets out of control.
Competitive advantage enables a company to generate high returns on capital. The relation between ROIC and time
measures the sustainability of company’s competitive advantage. The longer a company can sustain a high ROIC, the
more value the company will create.
Factors determining sustainability of the competitive advantage 11:

(1) Length of the product life cycle
Products with longer life cycles (e.g. Cheerios as a branded cereal product has a very long market position).
Unique access to a resource (e.g. palladium-rich nickel ore).
Business models that lock-in customers (e.g. Microsoft Windows).
(2) Persistence of the competitive advantage
In general, advantages arising from brand and quality on the price side and scalability on the cost side
tend to have more staying power than those arising from more temporary sources of advantage, such as
innovation, which tends to be superseded by subsequent innovations.
Price and cost advantages need to be realizable by a company. For e.g. self-service kiosks at airports as a
cost improvement didn’t translate into higher ROICs for airlines because every company had access to the
technology. Cost improvements were passed directly to the consumer in a form of lower ticket prices.
(3) Potential for product renewals
Consumer goods excel at using their brands to launch new products (e.g. Apple introducing iPad, iPod, iPhone;
Bulgari moving into fragrances, Mars entering ice cream business).
Being good at innovation helps companies renew products and lines of business.
For many companies their competitive edge disappears quickly and therefore, they will not yield superior returns.
Company will only create value for its investors if it manages to sustain high ROIC over a long period of time.
Competitive advantage Challenge Example
Product innovation Commoditization and disruption make customer lock-in GoPro, Fitbit
incredibly difficult.
Trending products Generate high returns for a short period of time. High fashion clothing
Dominant market share May be vulnerable to new entrants. Additionally, very large GM, Dell
firms may have an unattractive cost structure.
9 Robert W. Holthausen, Mark E. Zmijewski, Corporate Valuation Theory, Evidence and Practice, (Cambridge Business Publishers), Chp. 2

Does technology ensure sustainability of the competitive advantage? Only sometimes, the key questions are:
How significant is this technology and is it fleeting? What is of that change magnitude?
How can a company keep churning out better technology than its competitors? Is it outspending on R&D? Does it
have a much larger scale (e.g. inherent technological complexity, research equipment)? Usually more measured
pace of research which unfolds in small increments and through relatively complex improvements is better
thus usually leaders stay in lead; examples:
o Since 1960s aircraft engines have been largely optimized and currently incremental changes come in
materials, coatings and design;
o Google, user data is used to refine its algorithms that improve internet search performance;
o Credit-scoring models of Experian are continuously updated with new data and thus improving.
Does a company keep a low profile? Does it compete with governments and academic institutions?
Investors should carefully examine sources, as well as the sustainability of company’s competitive edge. One of the best
tools to measure competitive advantage, beyond qualitative insights is the ratio analysis.
Steps in the financial ratio analysis:12

(1) Understand target’s and its peers’ business models
(2) Form a hypothesis regarding target’s competitive advantage
(3) Adjust companies’ financial statements for differences and potential distortions due to accounting principles
(4) Classify assets to discover and confirm potential competitive advantage
(5) Compare ratios of the target to the ratios of its peers and observe changes in ratios over time
Three most important ratios are ROIC, ROA and ROE13

ROIC – shows how efficiently a company is using all investors’ funds (equity and debt) to generate income.
ROE – shows how efficiently a company is using equity investors’ funds to generate income.
ROA – shows how efficiently a company is using its assets to generate income.
ROIC - Return on Invested Capital (ROI - Return on Investment) = Unlevered Income / Average Invested Capital 14
Measures the effectiveness of company’s capital allocation.
o Best demonstrate industrial positioning and competitive advantages
In theory, the return on capital should equal the opportunity cost of capital.
Adjustments to correctly calculate ROIC:

Numerator: Tax rate for interest = effective income tax rate = income tax expense / income before taxes
Denominator: Some analysts add non-current net deferred tax liabilities to common equity under the assumption that
this is not really a liability and that stockholder’s equity was reduced when the deferred tax liability was recorded
We don’t need to adjust the denominator, since it does not include investments by non-controlling or minority
shareholders. Similarly, we don’t adjust the numerator for the net income for non-controlling or minority interest.
𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐼𝑛𝑐𝑜𝑚𝑒 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + (1 – Income Tax Rate for Interest) ∗ Interest Expense
𝑹𝑶𝑰𝑪 = =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 Average (Book Value of Debt + Preferred Stock + Common Equity)
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + (1 – Income Tax Rate for Interest) ∗ Interest Expense

=
Total Assets – Operating Liabilities
The return on capital (ROIC) is driven by three elements:15

Asset turns measure how efficiently a company generates sales from additional assets.
Profit margins benefits of incremental sales.
Cash conversion reflects company’s working capital intensity and conservatism of its accounting policies.
13 Ibid.
14 Ibid.
(Petersfield, Harriman House, 2015), Chapter 1

Asset Turns16
Measure of company’s asset intensity how much capital is needed to remain in the business to generate sales.
Asset light industries are attractive, since they require less capital to be deployed to generate sales.
o Franchise operations such as Domino’s Pizza, where growth is funded by franchisees;
o Software businesses, such as Dassault Systems (European developer of design software);
o One risk of low capital intensity is attracting competition (e.g. online gambling). Therefore, there is a need
for additional competitive advantage such as brand or intellectual property;
o High capital intensity can be attractive since if confers stability and deters entrants.
Profit Margins17
Gross profit margins are the purest expression of customer valuation of the product.
High, sustained gross profit margins relative to industry peers indicate durable competitive advantage.
High gross margins confer:
o Scope for operating leverage;
o Buffer against rising raw material prices;
o Flexibility to drive growth through R&D or advertising and promotion.
Strong competitive advantage = high operating margins + high gross margins.
Working capital (current assets – current liabilities)

Current assets = cash, cash-like assets and other assets expected to be used or converted into cash within one year
of within the company’s normal operating cycle, whichever is longer.
Current liabilities = liabilities which mature or are discharged within one year.
Sometimes we exclude short-term debt from current liabilities and excess assets from current assets.
Working capital ratios:

Current ratio measures the ability of a company to pay its current liabilities given the relative magnitude of its
current assets.
Quick (Acid Test) Ratio measures the ability of a company to pay its current liabilities given relative magnitude
of the company’s more liquid current assets.
Operating Cash Flow to Current Liabilities Ratio measures the ability of a company to pay its current liabilities
with its cash flow.
Be careful about the quality of company’s net account receivables. Check Provision for Bad Debts Ratio =
Allowance for Uncollectible Accounts / Gross Accounts Receivable.
Cost of working capital:

Working capital often reflects the bargaining power with other stakeholders;
For some companies working capital is negative (some industries like software or insurance require prepayments);
Among European companies working capital equals ~15% of sales.
ROE - Return on (Common) Equity18 = Income to Common Equity / Average Common Equity
This figure is crude because return measures should demonstrate cash return from each dollar invested by a business
irrespective of the capital structure and accounting techniques.
o Net Income is an accounting measure thus can be manipulated by depreciation, provisioning etc.
o There are several factors affecting shareholder’s equity, such as write-downs, debt levels and leverage effect
of debt. They boost return on equity, but do not reflect the associated risks.
𝐼𝑛𝑐𝑜𝑚𝑒 𝑡𝑜 𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 Net Income – Preferred dividends

𝑹𝑶𝑬 = =
Average Common Equity Average Common Equity
17 Ibid.

DISAGGREGATING RETURN ON CAPITAL19
Disaggregating ROE (levered) Formula
ROE Levered Profit Margin * Asset Utilization * Financial Leverage Factor
Levered Profit Margin (Net Income - Preferred Stock Dividends) / Revenue
Asset Utilization Revenue / Average Total Assets
Financial Leverage Factor Average Total Assets / Average Equity
Disaggregating ROE (unlevered) Formula

ROE ROA * NEFLF
ROA Unlevered Profit Margin * Asset Utilization
Non-Equity Financing Leverage Factor Earnings Leverage Factor * Financial Leverage Factor
ROA Unlevered Profit Margin * Asset Utilization

Unlevered Profit Margin [Net Income + (1 – Income Tax Rate for Interest) * Interest Expense)] / Revenue
Asset Utilization Revenue / Average Total Assets
Unlevered Profit Margin 1 - ALL COSTS + INTEREST INCOME

COGS to Revenue COGS / Revenue
D&A to Revenue Depreciation and Amortization / Revenue
Advertising Expense to Revenue Advertising Expense/ Revenue
Operating Expenses to Revenue Operating Expenses/ Revenue
Tax Expense to Revenue Adjusted Income Tax Expense / Revenue
Interest Income to Revenue Interest Income / Revenue
Asset Utilization 1 / SUM OF RATIOS BELOW

Cash to Revenue Average Cash / Revenue
Inventory to Revenue Average Inventory / Revenue
Other Current Assets to Revenue Average Other Current Assets / Revenue
Net Fixed Assets to Revenue Average Net Fixed Assets / Revenue
Other Assets to Revenue Average Other Assets / Revenue
Non-Equity Financing Leverage Factor Earnings Leverage Factor * Financial Leverage Factor
Earnings Leverage Factor Income to Common Equity / (NI + (1 - Income Tax Rate) * Interest Expense)
Financial Leverage Factor Average Total Assets / Average Equity
Financial Leverage Factor 1 + SUM OF RATIOS BELOW

AP to Equity Average Accounts Payable to Average Equity
AE to Equity Average Accrued Expenses to Average Equity
CP of LT Debt to Equity Average Current Portion of Long-term Debt to Equity
LT Debt to Equity Average Long-Term Debt to Equity
NCL to Equity Average Non-Current Liabilities to Average Equity

ROA - Return on Assets20 = Unlevered income / Average total assets
Adjustments to correctly calculate ROA:

Numerator: Tax rate for interest = effective income tax rate = income tax expense / income before taxes.
Necessary to account for:
o Non-controlling interest and minority interest adjust net income from subsidiaries.
Be aware of average level of assets if there were:
o Major acquisitions quarterly or pro-forma calculation based on transaction assumptions;
o Divestitures quarterly or proforma calculation;
o Highly seasonal businesses quarterly or proforma calculation.
Unlevered income Net Income + (1 – Income Tax Rate for Interest) ∗ Interest Expense
𝑹𝑶𝑨 = =
Average Total Assets Average Total Assets
Adjusting Ratios for Excess Assets: 21

It is important to adjust the ratios for excess assets because our goal is to reflect the profitability of company’s
operations in order to compare it to its peers. Some companies have substantial amount of excess assets (e.g. Apple).
Adjust income from the numerator by subtracting: income from excess assets, income from discontinued operations,
one-time expenses from reorganizations and extraordinary items.
By disaggregating ROA into Unlevered Profit Margin and Asset Utilization, we can examine the drivers of this ratio.
ROA = Unlevered Profit Margin x Asset Utilization

Unlevered Profit Margin = (Net Income + (1 – Income Tax Rate for Interest) * Interest Expense)/Revenue.
Asset Utilization = Revenue / Average Total Assets.
This disaggregation ties back to our discussion about the competitive advantage. Observing the patterns of change in
unlevered profit margins can reveal price premium advantages, for e.g. consistently high gross margins (COGS to
Revenue ratio). On the other hand cost and capital efficiencies can be witnessed both through examining
Unlevered Profit Margin and Asset Utilization, for e.g. Inventory to Revenue ratio.
21 Ibid.

When assessing the competitive advantage, one should select relevant comparable companies within the industry
and then map the performance in percentiles of the target company in comparison to its peers given how
different ratios change over time.
When comparing ratios between companies, it is important to treat accounting items consistently:
Some companies include depreciation in COGS and other show it as a separate line item;
Companies use different accounting methods for inventory: LIFO, FIFO;
We should exclude non-operating revenues from our calculations.
Issues to consider when calculating ratios:22

When calculating ratios be aware of seasonality.
Typically calculate ratios using LTM (last twelve months) or TTM (trailing twelve months).
Be aware of possible different fiscal year-ends.
Adjust the data for influential observations (outliers) to adjust:
o Use the median instead of the mean;
o Trim the distribution (exclude certain percentages of observations);
o Winsorize the distribution set a certain number or percentage of the observations in each tail of the
distribution at a “reasonable” value.
Negative denominators do not make meaningful ratios.
Inflation adjustments choose appropriate inflation index.
Be aware of accounting rules, for e.g. off-balance sheet financing or operating leases.
Remember that Accounting Rates of Return DO NOT equal Economic Rates of Return because:23
Income and investment base do not represent the economic income and an economic investment base.
Accounting is done at historical costs, not current values.
Expenditures for investments in brand development, company-developed intellectual property, organizational
infrastructure (e.g. existing distribution systems and channels) and human capital are generally expensed and thus
reduce accounting book value. Accounting system doesn’t treat these expenditures as part of company’s invested
capital although these investments create long-term value for companies.
Think carefully about minimizing expenses:

Companies have to expense an expenditure (instead of capitalizing it) for which the future benefits cannot be
reasonably measured, even though the expenditure likely has future benefits. For e.g. expenditures on marketing or
research and development. Minimizing those expenses is not necessarily consistent with maximizing the value
of the firm.
Maximizing asset utilization cannot be at the expense of future performance. For e.g. cutting inventory levels leads to
greater inventory turnover at first, but if the customers begin to experience delays in receiving order, the sales will
likely decline.
Always do a per unit analysis:24

Analyze revenues, assets, cash flows per employee, per unit of capacity or per unit of output basis.
o Measures based on output to realize the average revenue and cost per unit of output.
o Revenue per transaction for an online retailer or revenue per check for a restaurant.
Operating income per employee is a proxy for productivity.
Measures based on unit capacity are a proxy for utilization.
It may be useful to adjust for inflation, given that numerators are affected by it, but denominators such as # of sq. ft.
or number of employees are not. Use CPI, PCI, industry specific inflation or some general index.
Always keep in mind the industry you are analyzing:
o For retail measure capacity using the number of square feet of retail space
o For paper mills and heavy manufacturing measure capacity using tons of productive capacity
o For the airline industry measure capacity using available seat miles
23 Ibid.
24 Ibid.

Consider per share basis
Number of shares outstanding = Number of shares issued net of the number of shares it has repurchased and not
reissued (called Treasury shares).
Basic earnings per share = net income to common equity / weighted average shares outstanding.
Weighted average shares outstanding = Number of shares outstanding during the year weighted by how long the
shares were outstanding during the year.
Diluted earnings per share = Net income to common equity / weighted average shares outstanding adjusted for
dilutive effects of non-equity securities (such as: convertible debt, convertible preferred stock, stock options).
For some companies basic and dilutives earnings are substantially different because of reliance on stock options to
compensate employees.
Cash Conversion Cycle (Trade cash cycle) = Accounts Receivable Collection Period + Days of Inventory Held - Days
of Payables Outstanding.25
Cash conversion cycle measures the length of time for which the company must finance its purchases. The greater
the number, the larger investment the company has to make in receivables and inventory net of payables.
Other cash metrics:
o CROCCI = cash returns on cash capital invested = after-tax cash earnings / capital invested after adjusting
for accounting conventions such as amortization of goodwill (measure the post-tax cash return on all capital
a company has deployed).
o CFROI = metrics of IRR adjusted for cyclicality or timing of acquisitions.
Understanding leverage26
Financial Leverage Ratios

Total Debt to Total Assets
Total Liabilities to Total Assets
Total Debt to Common Equity
Debt is sometimes difficult to define and measure for two reasons:27

Not all liabilities on the accounting balance sheet are debt
o Liability = has 3 essential characteristic:
It embodies a present duty or responsibility to one or more entities that entails settlement by
probable future transfer or use of assets at a specified or determinable date, on occurrence of a
specific event or on demand.
The duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the
future sacrifices.
The transaction or other event obligating the entity has already happened.
o Debt = notes, mortgages, bonds (debentures) and other financing instruments which have an implicit or
explicit interest rate attached to them.
o This definition excludes: deferred income taxes, unearned revenue, most other operating liabilities (for e.g.
accounts payable, wages payable, accruals).
o For other reasons, convertible notes and convertible debt are also not entirely debt, even though accountants
may classify them as debt on the financial statements. Convertible nature makes it a claim on equity and the
value of convertible feature is not debt.
Companies can use debt which doesn’t show up on the balance sheet = “off-balance-sheet financing”
o For e.g. lease that doesn’t appear on the balance sheet (operating lease) new accounting rules require
companies to recognize the present value of most of these obligations on the balance sheet.
o Future obligation on the balance sheet to make certain payments for fixed or minimum quantities to be
delivered in the future unconditional requirements need to be disclosed in footnotes, but don’t have to
be shown on the balance sheet because payments have not been received.
27 Ibid.

Companies use SPVs = SPEs = Special Purpose Vehicles = Special Purpose Entities = “Bankruptcy-remote Entity” to
transfer risk from the balance sheet to another entity (e.g. Enron) subsidiary company with an asset and liability structure
that isolates it from the parent company. It is used to isolate financial risk, for e.g. finance a large project without putting
the entire firm at risk.
Financial instruments, which may be classified as debt, but do not have the characteristics of a debt instrument:
Exchangeable debentures
Interest rate swaps
Recourse obligations on receivables sold
Options
Financial guarantees
Interest rate caps
Interest rate floors
Future contracts
Forward contracts
Coverage Ratios28 measure the ability of a company to pay its fixed charges.
Interest includes all interest payments, even capitalized interest companies typically expense all interest accrued or
paid, but in some cases if company borrows money to finance the construction of a long-lived assets, the company
will capitalize the interest.
Sometimes companies issue zero-coupon debt or paid-in-kind debt (PIK debt) depending on an analysis we might
want to include or not include no interest debt.
A common adjustment is to treat non-capitalized (operating) leases as capital leases.
Analysts typically don’t include required principal repayments in fixed charges.
Concluding remarks about the competitive advantage:

Companies can achieve a competitive advantage with a variety of combinations of differentiation and cost strategies.
Sustaining a competitive advantage is not permanent and can erode quickly without ongoing focus on innovation.
Key questions:
o What is the source of the competitive advantage?
o What are the core competencies that the company has created to sustain that competitive advantage?
o How easy is it for someone to imitate its success?
o How likely is it that the nature of the competitive advantage will shift due to either external shocks, changes
in regulation, new technologies, competitor innovation or any other source?
o How nimbly can the company react to those shifts in competitive advantage?
Be skeptical about management’s statements about company’s competitive advantage. Observe the data and conduct
the ratio analysis.
Ask additional questions:
o Is it a process or a technology that is patented and difficult to imitate in other ways?
If so, how much longer does the patent last and what is the likelihood that similar outcome can be
achieved through a different process or technology before then?
o Is the competitive advantage a long-term contract on an important raw material for production that
guarantees a supply at a lower price?
If so, what is the length of the contract? Could the competition utilize alternative materials with
somewhat different manufacturing techniques to lower its costs?
o Is the competitive advantage the result of a unique process in manufacturing or some support service such
as procurement or distribution?
If so, how obvious are the necessary capabilities that support that process and how difficult would
it be to replicate the capabilities required for that process?

ALLOCATING CAPITAL TO DRIVE VALUE
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑔𝑒𝑛𝑒𝑟𝑎𝑡𝑖𝑜𝑛 (𝐹𝐶𝐹) × 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘 𝑹𝒆𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 (𝑹𝑶𝑰𝑪) × 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐺𝑟𝑜𝑤𝑡ℎ 𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑖𝑒𝑠
Effective capital allocation is critical for future cash generation. A company can allocate capital in four main ways, in:
(1) Capital expenditures;
(2) Investments in R&D, advertising and promotion;
(3) Mergers and acquisitions;
(4) Distributions to shareholders through dividends and buybacks.29
Capital expenditures (CapEx): 30

Growth CapEx increases future potential for cash generation, while maintenance CapEx in necessary to keep the
current operations.
o Maintenance CapEx is equivalent to ordinary operating expenses and thus predictable.
o Growth CapEx is deployed for a purpose of generating organic growth.
Investments in R&D, advertising and promotion (A&P): 31

Although financial statements classify advertising cost as an expense, investor should think about it as an investment.
Therefore, reclassification makes sense because advertising is far more flexible expenditure than most costs.
Contemporary accounting rules allow companies to treat some R&D disbursements more like long-term assets. They
have a dual nature: some are an expense necessary to maintain a business, while others (vast proportion) are best
viewed as investments in the future growth.
Historical R&D returns is often the best indicator of R&D efficiency.
A&P is an investment. For e.g. Dove soap (Unilever) sales result from decades of historical marketing spending to
build brand (created a mental consumer barrier).
Mergers and acquisitions (M&A):32

Acquisitions are a common source of value destruction. Typical red flags accompanying poor acquisitions are:
diversification, scale, rapidity, expansion to new areas without having sufficient expertise, clumsy business/culture fit.
Cases when acquisitions create value for shareholders:
o Consolidation of fragmented industries (roll-ups)
EssilorLuxottica, global leader of making lenses for eyeglasses, has a long term history of small
bolt-on acquisitions to get local customer base and better control of the value chain.
o Buying a business/brand that is already strong
Luxottica bought Oakley, already a successful sports eyewear brand, multiplied Oakley’s
distribution channels and created crossover branding to other premium fashion products, including
women’s wear.
o Leveraging network benefits (larger and more comprehensive distribution network)
Diageo, world-famous beverages company, regularly adds good, but under-penetrated brands to
the global portfolio, such as Zacapa, to improve distribution into new markets for existing brands.
Dividends and buybacks:

Excess cash (funds not needed to develop the business) should be distributed to company shareholders.
Too often companies:
o Repurchase excessively during economic expansion and overpay;
o Insufficient repurchase during downturns when shareholders need cash.
The higher a company can raise its ROIC and the longer it can sustain a rate of ROIC greater than its cost of
capital, the more value it can create. Therefore, being able to understand and predict what drives and sustains ROIC is
critical.
29Torkell T. Eide, Patrick Hargreaves and Lawrence A. Cunningham, Quality Investing: Owning the Best Companies for the Long Term,
30 Ibid.
31 Ibid.
32 Ibid.

ROIC = (1 – Tax Rate) * (Price per Unit – Cost per Unit) / Invested Capital Per Unit
Key drivers of ROIC:33

Competitive advantage
o Price premiums;
o Cost advantages (at lower cost or lower capital per unit);
In a business with increasing returns to scale, the first competitor to grow big can generate very
high ROIC and will usually create the bulk of value in the market (for e.g. E-Bay for which a
marginal cost of each additional buyer or seller is close to zero).
Structure-conduct performance
o Developed by Edward Mason in 1930s.
o Thesis: the structure of an industry influences the conduct of the competitors, which in turn drives the
performance of the companies in the industry.
o Then in 1980s Michael Porter published Competitive Strategy applying the model to company strategy. He
established that an intensity of the competition in the industry is determined by 5 forces:
Threat of new entry;
Pressure from substitute products;
Bargaining power of buyers;
Bargaining power of suppliers;
Degree of rivalry among existing competitors.
ROIC varies significantly across industries:34

On average, ROIC in Pharmaceuticals and
biotech > Consumer goods > Commodities.
o Pharma can develop innovative products that
are subsequently protected by long-lasting
patents.
o Consumer goods have developed long-lasting
brands that protect them against new
competitors (competition for shelf space on
factors other than just price).
o Commodities have undifferentiated products
and few opportunities for innovation. Difficult
to charge a price premium or build a sustainable
cost advantage.
Key findings:
Median ROIC between 1963 and 2008 was
around 10% and remained relatively constant.
ROIC varies drastically across companies, with
only 50% of observed ROICs between 5% and
20%.
ROICs differ by industry, but not by company
size.
Companies relying on sustainable competitive
advantage such as patents and brands (e.g.
pharmaceuticals, personal products) tend to have
higher ROICs (15-20%) vs. basic industries (e.g.
paper, airlines, utilities) that earn low ROICs (5-
10%).
There are large variations in rates of ROIC between and within industries.
ROIC rates after acquisitions tend to be fairly stable returns with goodwill were flat, which means that companies
were not able to extract much value from their acquisitions.
34 Ibid.

Top industries: pharma, software, IT, beverages, personal products.
Software companies benefit from scalability, but in comparison to pharma have less patent protection and shorter life
cycles, thus generate a wider distribution of returns.
ROIC rarely varies with size which means that economies of scale are rarely a source of competitive advantage.
Companies reach minimum efficient scale at relatively small sizes.
Persistence of ROIC - patterns across industries:
Trending down Persistently low Cyclical Persistently Trending Up Persistently

medium high
Trucking Paper and forest Chemicals Machinery Household and Health-care
products personal equipment
products
Advertising Railroads Semiconductors Auto Beverages Aerospace and
components defense
Health-care Utilities Oil and gas Electrical Pharmaceuticals
facilities equipment
Automobiles Department Metals and Restaurants Software
stores mining
Research shows a persistence of ROIC performance beyond 10 years. Although best-performers cannot maintain
outstanding performance over the long-term, their ROIC does not revert all the way back to the aggregate
median. High-performing companies are in general remarkably capable of sustaining a competitive advantage in their
businesses and/or find new businesses where they continue or rebuild such advantages. Similarly, if a company earns a
low ROIC, that is likely to persist as well.
Basing a continuing value calculation on an assumption that ROIC will approach WACC is overly conservative
for a typical company generating high ROICs. We should benchmark decay of ROIC by industry.
UNDERSTANDING GROWTH
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑔𝑒𝑛𝑒𝑟𝑎𝑡𝑖𝑜𝑛 (𝐹𝐶𝐹) × 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝑅𝑂𝐼𝐶) × 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝑮𝒓𝒐𝒘𝒕𝒉 𝑶𝒑𝒑𝒐𝒓𝒕𝒖𝒏𝒊𝒕𝒊𝒆𝒔
It may sound trite, but the best businesses play on the markets that grow rather than shrink. If the “pie” is not growing,
then competitors want to grab market share through industry destructive tactics like price discounts and promotions.
Revenue growth can be: (1) organic (build or borrow strategy) or (2) inorganic (buy strategy).35
Organic revenue
o Portfolio momentum due to an overall expansion in market segments represented in the portfolio.
o Market share performance gaining or losing share in any particular market (market share defined as a
company’s weighted average share of the segments in which it competes).
Inorganic growth (M&A or divestments)
Gaining market share:36

Can occur both in economic expansion and contraction.
It is something which a company itself has some degree of control over (vs. overall market growth).
Can be achieved through various initiatives:
o Compelling advertising campaigns;
o Successful store roll-outs (H&M);
Edition, (John Wiley & Sons, Inc. Hoboken, New Jersey), Part One

o Ongoing investment in distribution.
Geographic expansion can be a good strategy, however, it is challenging to expand abroad if the business is relying
on a unique competitive advantage at home such as: distribution system, localized scale advantages or regulatory
environment, for e.g. grocery retailers, hospital operators, airlines.
Best companies enjoy a diversified set of growth drivers, broken down into: (1) price, (2) product mix and (3) volume. 37
Price
If a company can increase its pricing without cost increases, it has a pricing power which is essentially cost-free. It
exists when customers are insensitive to price increases:
o Consumers consider quality or status (luxury items);
o Products are marked on reputation when comparisons with alternatives is difficult (e.g. organic food).
Product Mix
Most common source of growth comes from price-mix optimization.
It is valuable because is associated with low CapEx and modest increases in working capital, but it is inferior to pure
price increase because it requires some production cost.
Volume
The least valuable because it entails increasing quantity at existing average unit economics.
It has a minor impact on gross margin, requires incremental CapEx and working capital.
Therefore, it is particularly valuable for asset-light and high operating leverage businesses (e.g. pharma, software).

Value of major types of growth38
VALUE TYPE OF GROWTH RATIONALE

No established competition, diverts consumer
Create new markets through new products
spending
ABOVE
Convince existing customers to buy more of
AVERAGE All competitors benefit, low risk of retaliation
a product
Attract new customers to the market All competitors benefit, low risk of retaliation
Competitors can still grow despite losing market
Gain market share in fast-growing market
share, moderate risk of retaliation
AVERAGE
Make bolt-on acquisitions to accelerate Modest acquisition premium relative to upside
product growth potential
Gain share from rivals through incremental
Competitors can replicate and take back customers
innovation
BELOW Gain share from rivals through product
Competitors can retaliate quickly
AVERAGE promotion and pricing
High premium to pay, most value diverted to
Make large acquisitions
selling shareholders
It is important to recognize cyclicality

of some industries. Different
businesses respond differently to
economic cycle: oil cycle is long,
agricultural deep, while consumer
shallow.
Cyclical markets pose an analytical

challenge because of unpredictable
upswing reverses due to increased
supply or reduced demand. One
needs to:
Understand the cycles that
specific companies face;
Analyze if a company is able
to deliver real earnings growth
through the cycle;
o Marriott and other hotels
gain share by adding rooms and
benefit from a cycle that tends to
show real growth from peak to peak.
Tim Koller, David Wessels, Marc Goedhart, McKinsey & Company, Valuation: Measuring and Managing the Value of Companies, 5th
38

Sustaining growth over a long period is difficult:39
Growth above GDP is capped by the size of the economy.
Most products have natural life cycles (S vs. C-curves).
To capture growth rate log transform the revenue curve high growth can come periodically from creating new
products and entering new markets during the high-growth, profitable phase.
To sustain high growth, companies need to overcome “portfolio treadmill” effect for each product that matures
and declines in revenues, the company needs to find a similar-sized replacement product to stay level in revenues.
Corporate growth insights:

Between 1963 to 2007, the median real revenue growth rate for companies was 5.4% (range of 0.9% to 9.4%).
High growth decays quickly. Firms which grew at first 20%, only grew 8% within 5 years and 5% within 10 years.
Really large companies (Fortune 50) on average grew only 1% (above inflation) over a period of 15 years.
Why companies real revenues grew on average 5.7% between 1963 and 2007, while real GDP grew 3.2%:
Global expansion of US companies.
Self-selection companies with good opportunities need capital to grow thus grow above average.
They became increasingly specialized and outsource services.
Difference between structural and cyclical growth:40

Structural growth refers to more permanent expansions supported by persistent trends deemed likely to endure.
Cyclical growth refers to growth sensitive to fluctuations of a business cycle.
40 Ibid.

Structural and cyclical growth can be confused, especially in emerging markets.
Be wary of general market trends. For e.g. US golfing industry was projected to increase in tandem with the population
growth, favorable demographics and increasing wealth. Instead from 2006 to 2013 the industry contracted 18%
despite a 6% growth in the US population.
Persistent growth assumptions:
o No relationship between growth rates achieved by any given company 5 years before and 5 years after
(according to I.M.D. Little, British economist).
o While sales and asset growth are weakly persistent, earnings growth is more random and uncorrelated with
preceding years (according to Credit Suisse HOLT research). The probability of sustaining elevated earnings
growth rates from one year to the next is negligible.
o Return on capital is more persistent and more reliable indicator of the future growth.
o There is a relationship between CFROI and higher future earnings.
Growth Rates and Trend Analysis:41

Examine the index trend
o Divide all years by the first year to measure the cumulative growth rate.
For e.g. if the trend index of sales goes from 1 to 1.5 over 5 years and the index trend of operating income goes
from 1 to 2 over the same period, then it indicates that the company is likely to benefit from economies of scale as
it grows. If the operating income trend index moves in lockstep with sales, then the firm is not experiencing any
economies of scale.
1
𝑿(𝒏) 𝑛
Calculate 𝐂𝐀𝐆𝐑 (compounded annual growth rate) = ( ) −𝟏
𝑋(1)
LINKING REVENUE GROWTH AND CAPITAL ALLOCATION
The math of value creation: how ROIC and revenue growth translate into value42
Definitions:
• NOPLAT = Net operating profit after taxes
• Invested Capital = amount invested in core operations, primarily working capital and PP&E
• Net Investments = Invested Capital (t+1) – Invested Capital (t)
• g = revenue growth
Logic: A company invests capital to generate profits, ROIC demonstrates the return on this invested capital. Afterwards
the company reinvests these profits back into the business at a given investment rate. The cash left in the business equals
company profits less the investment in a given year. Thus FCF equals the percentage of company profits not reinvested
(NOPLAT x (1 – IR).
𝑁𝑂𝑃𝐿𝐴𝑇
𝑹𝑶𝑰𝑪 =
Invested Capital
𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑰𝑹 = 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 =
NOPLAT
𝑭𝑪𝑭 = 𝑁𝑂𝑃𝐿𝐴𝑇 − 𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝑁𝑂𝑃𝐿𝐴𝑇 − (𝑁𝑂𝑃𝐿𝐴𝑇 𝑥 𝐼𝑅) = 𝑁𝑂𝑃𝐿𝐴𝑇 𝑥 (1 − 𝐼𝑅)
Logic: Company revenues will grow at a rate equal to the return on invested capital given company’s investment rate.
Therefore, company cash flows will equal the percentage of profits not reinvested in the business at a given revenue growth
rate of the return on invested capital.
𝑔
𝒈 = 𝑅𝑂𝐼𝐶 𝑥 𝐼𝑅 → 𝑰𝑹 =
𝑅𝑂𝐼𝐶
Robert W. Holthausen, Mark E. Zmijewski, Corporate Valuation Theory, Evidence and Practice, (Cambridge Business Publishers), Chp. 2
41
Tim Koller, David Wessels, Marc Goedhart, McKinsey & Company, Valuation: Measuring and Managing the Value of Companies, 5th
42

𝑔
𝑭𝑪𝑭 = 𝑁𝑂𝑃𝐿𝐴𝑇 𝑥 (1 − 𝐼𝑅) = 𝑁𝑂𝑃𝐿𝐴𝑇 𝑥 (1 − )
𝑅𝑂𝐼𝐶
Logic: The value of the company equals all future discounted cash flows. If company profits are a return on invested
capital, then the profits not reinvested in the business equal free cash flows. Overall, the value of the company equals a
return on invested capital that grows driven by the revenue growth and return on invested capital given the underlying risk
of the business.
Disclaimer: This model is too restrictive because it assumes a constant ROIC and revenue growth rate.
𝑵𝑶𝑷𝑳𝑨𝑻 = 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑥 𝑅𝑂𝐼𝐶

𝑔 𝑔
𝐹𝐶𝐹 𝑁𝑂𝑃𝐿𝐴𝑇 𝑥 (1− ) 1−
𝑅𝑂𝐼𝐶 𝑅𝑂𝐼𝐶
𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒄𝒐𝒎𝒑𝒂𝒏𝒚 = WACC−g = = 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑥 𝑅𝑂𝐼𝐶 𝑥 𝑊𝐴𝐶𝐶−𝑔
𝑊𝐴𝐶𝐶−𝑔
𝑔
𝑽𝒂𝒍𝒖𝒆 1−
𝑅𝑂𝐼𝐶
= 𝑅𝑂𝐼𝐶 𝑥 𝑊𝐴𝐶𝐶−𝑔
𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
𝑔
𝑷 𝑉𝑎𝑙𝑢𝑒 1−
𝑅𝑂𝐼𝐶
= NOPLAT = 𝑊𝐴𝐶𝐶−𝑔
𝑬
Translating Growth and ROIC into value
ROIC depends on the maturity of the industry:43

For young, startups when a company grows, its ROIC will naturally increase.
In mature companies, a low ROIC indicates often a flawed business model or unattractive industry structure.
Market values companies for two factors revenue growth and ROIC:
For e.g. in CPG industry, like P&G and Colgate-Palmolive, although companies are not high growth, they earn high
earnings multiples because of their high returns on invested capital.
Comparison of Campbell-Soup Company and Kohl’s:
o Campbell’s revenues grew only 4% annually, while Kohl’s 15%.
o However, their P/Es are similar because Campbell achieves ROIC of 50%, while Kohl’s only averaged 15%.
Why do US firm earn higher multiples than Asian companies? 44 A common misconception comes from an assumption
that investors are willing to pay higher prices (maybe due to lower risk), however, the real answer is that American
companies earn typically higher returns on invested capital (median US ROIC is 16% vs. median Asian ROIC of 10%).
44 Ibid.

Key insights for managers:45
Companies already earning high ROIC can generate more additional value by increasing their growth rate.
Low-ROIC companies will generate relatively more value by focusing on increasing their ROIC.
Typical High ROIC company (e.g. CPG)

1% revenue growth translates into 10% value increase
1% higher ROIC translates into 6% value increase
Typical Moderate ROIC company (e.g. retailer)

1% revenue growth translates into 5% value increase
1% higher ROIC translates into 15% value increase
Overall lesson: high-ROIC companies should focus on growth and low-ROIC companies should focus on improving
returns before growing.
Type of growth46 Shareholder value created for incremental $1 of revenue

Introduce new products to market $1.75 - $2.00
Expand an existing market $0.3 - $0.75
Increase share in a growing market $0.1 - $0.5
Compete for share in a stable market -$0.25 - $0.4
Acquire a business $0 - $0.2
Understanding nuances:
New products often fail, while acquisitions are more reliable.
Acquisitions require the entire investment up-front. They usually earn a return only a small amount higher than its
cost of capital because payment reflects future cash flows plus a premium to stave off other bidders.
Organic new products have highest returns because they don’t require much new capital.
o For e.g. adding new products to existing factory lines and distribution systems.
o Investments are not required at once. If preliminary results are not promising, future investments can be
scaled back or canceled.
Acquisitions create value only when: combined cash flows of two companies are higher than individual due to a) cost
reductions, b) accelerated revenue growth, c) better use of fixed and working capital. Keep in mind multiple expansion
fallacy of higher P/E company buying lower P/E company.
How should companies make investment decisions?47

Price of risk = cost of capital: price charged by investors for bearing the risk that the company’s future cash flows may
differ from what they anticipated when they make the investment. It is a minimum return that investors expect to earn
from investing in the company.
When to invest in a project: If a company earns ROIC of 50%, it should still invest in projects yielding 25% ROIC as
long as it is above their cost of capital. The principle of value creation states that you should allocate capital to any
investment that increases cash flows.
Deciding between projects: When evaluating two projects and forecasting cash flows, it is better to say with what
probability will you get what cash flow because that helps evaluate risk. There are two things to consider:
Difficulty to calculate an appropriate cost of capital (discount rate).
46 Ibid.
47 Ibid.

Risk of losing the entire cash flow (for e.g. there is a 40% chance of losing the entire capital, even though the
expected value for the project is $4,000). Ask yourself if losing the entire cash flow bankrupts the company?.
What drives returns to shareholders?48
Total Returns to Shareholders (TRS) = Appreciation in share price + Sum of dividends paid over the period
TRS = Percentage Change in Share Price + Dividend Yield
TRS = Percentage Change in Earnings + Percentage Change in P/E + (Interaction between Share Price and P/E changes)
+ Dividend Yield
Issues:
Managers might assume that all forms of earnings growth create value, but that is not true because different sources
of earnings growth may generate different returns on capital and therefore cash flows.
This approach suggests that the dividend yield can be increased without affecting future earnings, but dividends are
merely a residual.
Traditional TRS approach fails to account for the impact of financial leverage (debt-to-equity ratios) which result in
differences in risk.
Approach to decomposing TRS:49

Growth: The value generated from revenue growth net of the capital required to grow reflects improvements in
margins and capital productivity. Shows how company’s operating performance changes over time.
Zero-growth return: What TRS would have been without any of the growth reflects company’s stock market
valuation at the beginning of the measurement period.
Change in P/E: Changes in shareholder’s expectations about the company’s performance, measured by the change
in P/E or other earnings multiples.
Financial leverage: The impact of financial leverage.
Decomposing TRS Traditional (unlevered) Enhanced (levered)

Growth 7.0 7.0
Required Investment (5.6)
TRS from Performance 7.0 1.4
Zero-growth return - 10.0

Change in P/E 5.5 (levered) 3.0 (unlevered)
Impact of financial leverage - 3.6
Dividend yield 5.5 0
TRS (percent) 18.0 18.0
TRS Example Target Wal-Mart Difference

Growth 9 13 (4)
Required Investment (5) (3) (2)
Change in margin 4 - 4
TRS from Performance 8 10 (2)
Zero-growth return 6 4 2
Change in Unlevered P/E 5 - 5
Impact of financial leverage 5 2 3
Other 0 (1) 1
TRS (percent) 24 15 9
49 Ibid.

Expectation treadmill in P/E shows how difficult it is for a company to grow when it is already matched with high
expectations (for e.g. Target TRS outperformed Wal-Mart’s TRS because Target started with 11 P/E and Wal-Mart with
15 and then they got to 16 and 18. Although Wal-Mart earned higher revenue growth 9 vs. 13% and ROIC of 15 vs. 24%,
Target was starting from a position of low shareholder expectations.
Over long 10+ years periods TRS improvements reflect actual performance of the company, but over short periods
they don’t because management bonuses are based on TRS.
Main insights:
Improving TRS is much harder for managers leading an already successful company than for those leading a
company with substantial room for improvement.
TRS does not show the extent to which improvements in operating performance contributed to the measure as a
whole. Improved operations constitute the only part of the measure that creates long-term value and is also
within management control.
Extraordinary managers may only deliver ordinary TRS because it is incredibly difficult to keep beating high
market expectations, which are built in the price.
Leverage has a multiplier effect on TRS relative to underlying economic performance, that is a 1% increase in
revenues leads to a greater than 1% increase in profits and share price. However, greater leverage increases the
risk of bankruptcy.
Effective compensation systems should focus on growth, ROIC and TRS performance relative to peers.
Historically GAAP accounting companies adopted fixed-price options rather than relative to peers to generate higher
accounting income.
Theoretically if a company’s performance exactly matches expectations, then its TRS will equal the cost of equity.
However, in practice due macro-economic factors impact TRS performance such as: interest rates, inflation
and economic activity.
Risk for companies whose shareholders already have high expectations is pushing unrealistic earnings
growth or pursuing risky acquisitions which may be value destructive in the long term (e.g. power generation
companies in 2000s).
Thinking about risk:
Diversifiable vs. systemic risk: If diversification reduces risk to investors and it is not costly to diversify, then investors
will not demand a return for any risks they take that they can easily eliminate through diversification. They require
compensation only for risks they cannot diversify, those are systemic risks that affect all companies (e.g. economic
cycle).
General rule: Avoid hedging commodity price risk because it can be managed by shareholders themselves. Instead hedge
currency risk (harder for shareholders to generalize).
For Heineken hedging is critical because it produces in Holland and exports to the US, thus revenues are in dollars
and costs are in euros. Assuming a 10% margin, a 1% decline in dollar will reduce Heineken’/s margin by 9%, and its
profits reported in euros will decline by 10%.
When to repurchase stocks?
Some managers argue that the management should repurchase shares when its shares are undervalued. Suppose
management believes that the current share price of the company doesn’t reflect its underlying potential. Has value been
created? No, share buybacks only shift ownership from one shareholder group to another. They don’t create value
themselves. Generally companies are not very good at timing their share repurchases, usually buy when the price is too
high.
Share repurchases logic:

Assume that a company borrows $100 to repurchase 10% of shares. For every $100 of shares the company will pay 6%
interest on new debt. After tax savings of 35% total earnings would decline by $3.9. However, the number of shares
decreased by 10%, so EPS increased by about 5%. However, because of the conservation of value principle, the total cash
flow of the business has not increased. Due to high leverage, company’s equity cash flows will be more volatile,
therefore investors will demand a higher return, which will bring the P/E down, offsetting an increase in EPS.

However, share buybacks may reduce the likelihood that the management will invest the cash at low returns.
This tactic helps avoid value destruction. But share buybacks themselves do not create value.
DISCOVERING PATTERNS OF SUCCESSFUL COMPANIES50
Some companies and industries are inherently more attractive than others. Thinking systematically about patterns of
successful companies is crucial in investment evaluation.
3 Cs Framework =
Customers = demographics, needs and willingness to pay of different customers segments
o Customer benefits
o Customer types
Competition = market share, structure and growth
o Industry structure
o Friendly middlemen
o Toll roads
Company = product offering, core competencies, profitability, unique selling point and financial performance
o Revenue
Recurring revenue
Pricing power
Brand strength
Market share gainers
o Cost
Low-price plus
Cost to replicate
o Operations
Good management
Innovation dominance
Forward integrators
Global capabilities and leadership
Corporate culture
Customers
(1) Customer Benefits – the reason why customers purchase a product

Intangible benefits
o Usually depend on taste or projected image, therefore, the price becomes secondary.
o Important in smaller items, which are often considered indulgence.
o Matter more to the customer, the more intimate they are.
Assurance benefits
o Willingness to pay a premium for the most reliable or the highest quality product.
o Often based on reputation of high quality and reliability earned over time.
o Parachute scenario – you care mostly about one feature, in the case of the parachute is that it works,
consequences of failure are seen to the consumer as devastating.
o Examples:
Manufacturing, for e.g. suppliers of industrial gases like oxygen and hydrogen.
Baby food, like Nestle’s Gerber, provides assurance that the food is healthy and safe.
Farmers pay a premium for tractors from John Deere.
Big Four offer well-known auditing services.
Convenience benefits
o Making product easily accessible and therefore paying for proximity. The sales model is based on
convenience and efficiency.
o Vulnerable to competition if a benefit is based solely on geography.

o Examples:
Strong salesforce who also play a role of advisors;
Banks adopting automatic payroll deposits and bill payments;
Telecommunication customers bundle cable, internet and phone products.
(2) Customer Types

Retail consumers fickle, acutely price-sensitive on some items and spendthrift on others. Willing to splurge on
items offering intangible benefits, particularly for smaller purchases.
Corporate clients
o Small companies can be more like consumers, generally cost-conscious, but occasionally willing to pay up
for intangible and convenience benefits.
o The larger the company is, the more objective its purchasing decisions are. It will focus on direct cost savings
and will have low willingness to pay for intangible or convenience benefits.
o Increasingly use procurement departments to enhance rational corporate buying behavior.
o Rules of thumb:
Buying corporations pay the greatest attention to high-priced transactions involving contracts made
at the highest levels in the organization. Companies can sell large numbers of lower-priced
goods to corporate customers where purchase orders are made and approved without
significant involvement of senior managers or the general counsel.
Sellers tend to do worst on products sold to corporations through bidding processes or
organized negotiations. Extensive product comparisons lead to intense competition among
suppliers which drives prices down.
Corporate buyers are more receptive to the concept of “total cost ownership”. Cost of
changing suppliers (due to embedded product in the entire production process) can be significantly
higher than simply the cost of the product (for e.g. software such as cheaper alternatives to SAP
fail because switching is painful and expensive both in terms of direct costs and disruption).
Corporate risk aversion (“No one ever got fired for buying IMB”).
Competition
(1) Industry Structure
The industry structure often determines the performance of companies within that sector
There are several types of industry structures: mini-monopolies, partial monopolies, oligopolies and duopolies.
Mini-monopolies (unregulated), for e.g. Microsoft in operating systems in late 20th century, Standard Oil in energy in
late 19th century.
o Usually arise from a product offering highly-valued customer benefits unavailable from rival goods.
o Examples of mini monopolies:
Equipment for repair;
Software upgrades.
Partial monopolies/broken competition
o Localized supremacy (Ambev’s 50% EBITDA margin).
o High switching costs because of a greater value in back-end product than in the front-end.
Oligopolies
o Companies get more profitable with higher concentration.
o Duopolies
Coca-Cola and Pepsi branded, fast-moving consumer goods;
Airbus and Boeing high-tech equipment with long lead time. Aircraft industry sells to a
concentrated industrial customer base and every sale is negotiated hard, which puts pressure on
pricing and results in lower profitability, therefore poor economics.
o Even when more competitors enter, companies often focus on fighting weaker while leaving stronger alone.
Hearing aid market – Sonova and William Demant – consistently taking share from weaker
competitors.
o Oligopoly is preferred to a fragmented and volatile competitive landscape.
Rationality
o Price wars destroy industries.
o Discounting is dangerous and short-sighted (e.g. laundry detergents).
Share donors

o Businesses that help rivals by ceding market share and profits on recurring basis due to poor performance.
o Most common sources:
Management incompetence (can be corrected).
Suboptimal product mixes (can be corrected).
Structural problems (best opportunity)
• Ignored divisions of large companies, such as Siemens hearing aid business.
• Smaller companies unable to scale up as an industry consolidates or globalizes (in
Germany beer and paint industries remain fragmented and competitive thanks to family-
run mid-size firms).
Entrenched cost or management structures that impair adaptability (e.g. airline industry with legacy
hub-and-spoke business model lost to low-cost point to point travel).
Security by obscurity of niche industries protection from a competitive disruption.
(2) Friendly Middlemen companies deal with middlemen to reach end consumers
Types of middlemen:
o The helping hand bundle delivery of company’s product with their own expert services
Both a salesman and an expert (e.g. dentist, optometrist) higher trust levels.
Customer paying for a professional installation of manufactured products (e.g. electrical or
plumbing contractors) product safety and reliability are paramount.
Customer lock-in Considerable variation of payoffs from three-party pattern. Professionals can be costly
gatekeepers, therefore to enable recommendation and promotion loop there must be:
o Product differentiation (e.g. reputation among doctors);
o Reliable customer service;
o Professional training for complex and difficult to install products (e.g. Bloomberg terminals) barrier to
entry and higher switching costs.
CASE STUDY – Geberit

Produces lavatory products, such as toilet flushing systems and pipes.
Introduced the first concealed flushing cistern. It made installation and repair more difficult, but gave aesthetics
benefits. Geberit made plumbers friendly middlemen.
Plumbers seek quality products, ideally those which are easy to install and unlikely to break. But they are price
insensitive because the end customer pays the bill. It enables capitalizing on the gap between decision-makers
(plumbers) and end-customers.
Geberit strengthens the relationship-based model by:
o Providing free training building loyalty;
o Protects plumbers by stressing both ease of installation and lifetime reliability (promotes plumbers
reputation);
o Investment in product R&D make compliant products with local regulation;
o High activity during economic downturns to increase loyalty countercyclical activity.
(3) Toll Roads companies, which have a position as a small, but vital suppliers are considered “toll roads”
Many large industries are served by niche suppliers whose services or products may represent a relatively immaterial
proportion of that industry’s cost base, but which are crucial to successful operations of the industry.
Position of a small, but vital supplier creates a significant barrier to entry. They are often oligopolistic and stable rather
than broad-based and unpredictable.
Examples:
o Professional certification – auditing, rating agencies, product testing (e.g. Fitch, KPMG);
o Specialty ingredients – for products as diverse as yogurt or motor oil.
Gold standards certain companies that customers simply accept as the gold standard
o Such as rating agencies: Moody’s, Standard and Poor. Simplify investor analysis and bring order to credit
market. Ensure stability of an industry and related barriers to entry (even despite errors in 2008).
o Independent verification or testing services offer value when a risk of error is high. For e.g. globalization
and increasingly complex value chains increased demand for independent verification.
o Training services because: (using Microsoft Excel)
can be costly;

repeated use increases knowledge;
switching costs are high;
promotes standardization.
Magic ingredients inputs bearing low cost, but high value in production processes
o For e.g. in food and beverage industries enzymes, flavors and fragrances (e.g. yoghurt production); in
industrial processes gases play a similar role (e.g. oxygen).
Industry structure and economics typically oligopolies, not monopolies
o Sole provider presents a cost to competition that is too great to pay, thus 3 credit rating agencies, 4 auditing
firms, 4 industrial gas providers, 3 testing companies.
o Understanding of oligopoly structure for decades to come leads players to healthy competitive behavior
rather than mutually destructive.
CASE STUDY – Christian Hansen

Started with calf-gut rennet complex enzyme used in cheese production.
Global leader in supplying cultures and enzymes to the food industry.
Provides consistent, superior product and therefore achieves high customer stickiness.
Reasons for customer stickiness:
o Absolute cost of the product is low, around 1% of input expense;
o Important impact on flavor and texture which are integral determinants of customer appeal;
o Improvement in customer’s process efficiency yielding cost savings.
Benefits of scale Large volume game Larger batches produce larger margins.
Have 45% of global market share and unmatched R&D budget.
Operating margins of 25%, ROIC of 35% and sales growth of 8%.
Company
Revenue
Recurring revenue
Pricing power
Brand strength
Market share gainers
Cost
Low-price plus
Cost to replicate
Operations
Good management
Innovation dominance
Forward integrators
Global capabilities and leadership
Corporate culture
REVENUE
(1) Recurring Revenue when an existing customer base buys additional services or products from a company
Recurring revenue models:
o Product upfront if a company struggles to generate new upfront sales at poor returns, related costs eat
into the gains of ensuing recurring revenues
Economics of upfront sales shuts down new entrants Since monopoly dynamics are known to
suppliers and buyers, suppliers may price inputs higher and customers may press harder for upfront
price concessions, which results in low margins.
o License model licensing fee that follows upfront product purchases (e.g. software industry), most
customers opt-in because there is a substantial risk of product inoperability or obsolescence.
o Service model repair, maintenance and overhaul revenue, with timing and extent that are uncertain

To make this model work the company must successfully compete against maintenance and service
options, spare parts third party distributors by converting new equipment sales into service
contracts.
Best is to have a portfolio of long-term service contracts with large customers who pay a fixed
annual fee.
Service models strengthen when the risk of damage from product disruptions are regulated or
mandated by law (e.g. elevators).
Source of strength when the breakdown of a piece of equipment is likely to cause economic
disruptions for its owner (e.g. having a ship docked is very expensive, therefore owners will likely
prefer premium ship engines with speedy repairs).
Overall rule product longevity influences the value. The longer the machine is used, the longer
it will need spare parts how much annual revenue can be expected as a % of upfront annual
sales (the bigger the % and the lengthier, the better).
o Subscriptions probably the least rewarding form, recurring revenue resides in prospects for subscription
renewals requires attention to lock-in mechanism
When the cost of switching is low, customers might quickly migrate (e.g. cell phones) strategy
to become low-cost producer rather than to exploit the value of recurring revenue.
Differentiated subscription occurs when a company lacks close rivals (e.g. The Economist).
Economic Effects
o In recurring revenue models customers fund provider’s business, which means that they pay ahead of
delivery of goods and services. It enables them to operate with negative working capital. Less resources
tied up in operations translates into lower costs and higher profits.
o For non-recurring revenue model, larger companies usually have greater costs of working capital.
o Subscription and services revenues
Tend to be billed in advance revenue turns into cash quicker cash earlier is more valuable
that cash later;
Tend to require little capital investment to support growth (e.g. software updates);
Usually asset-light.
Density and network benefits
o Higher installed base Density economics contributes value for e.g. the more installed equipment in
the region, the more efficient maintenance becomes because the personnel spends less time traveling.
o Network effects the larger the service network, the faster it can meet customer needs, mostly high speed
of repairs.
Most powerful when obligations to pay for the service are locked in (e.g. software upgrades). The larger the installed
base, the bigger the monopoly and the more predictable revenue streams.
Recurring revenue models offer an attractive combination of (often):
o negative working capital + rapid cash collection + low capital expenditures.
Examples: jet engines requiring service, security systems with trailing surveillance and response, periodicals with
subscription renewals.
CASE STUDY – Kone

Elevators’ original 1850 technology remains unchanged.
One of the largest elevator companies together with ThyssenKrupp, Schindler and Otis Elevators. They control ~70%
of the global market.
Revenue = 50% Upfront sale + 50% Service revenue in perpetuity (maintenance + upgrades)
o Upfront sale margins are low;
o Service revenue delivers ~30% margin and high ROIC (attach rate ~90%) due to pricing power;
There is density economics since the more elevators in the area, the more efficient the service.
Business profitability is consistent with cyclicality of the construction activity.
Service fees are paid upfront so their working capital is negative.
(2) Pricing Power company can regularly raise prices above the cost of inflation, with no capital expenditure required
to raise prices, which enhances the return on capital.
In reality no company has absolute pricing power to raise prices without volume decline.
Pricing power is typically held by monopolies or mini-monopolies, thus it refers more to a competitive structure
rather than product type.

Companies which have pricing power usually prefer to conceal it as the less customers, competitors and regulators
know, the better. Therefore, they bundle pricing power with product enhancement.
Conditional pricing power company enjoys pockets of power due to a selective, but recurring sales context.
Pricing for value for e.g. in computer software when vendors add small features accompanied by substantial price
increases
o E.g. seeds for farmers – Monsanto develops seed products that improve farm yields by 1-2% annually.
Strategy of sharing the value upside with the farmer, raising prices each year to a level that means about one
third of this benefit accrues to them, with the farmer getting the rest. A company that can continuously
develop products, while pricing for value can build a durable pricing power.
Downside: price deflation
o Often occurs in industries with substantial volume growth and significant innovation, for e.g. hardware
technology industry.
o Can be tolerable in the short term if volume increases and gains from operational efficiencies/declining
equipment cost outweigh losses. But in the long run the economic prospects of such firms remain negative.
That is why many companies in such industries ultimately fail (although there are always some potential
long-term winners).
Example: historically the only newspaper in town.
CASE STUDY – Hermès

Started with harness and saddlery workshop in 1837.
Created a Birkin bag pricing is premium even over other luxury brands what explains the pricing power:
o Exceptional quality single artisan up to 20 hours per item;
o Refined image 80% of sales are made through company-owned stores in choice locations and the rest
through international airports; exceptional service; exterior design and interior layout of the store;
o Scarcity reinforces pricing power waiting lists + genuine rarity of some items;
o High control over distribution of its products gives complete authority over pricing;
o Price elasticity of demand is negligible the more expensive the item gets, the more desirable it can become.
Overall compelling company characteristics: 30% operating margins, 30% ROIC, 11% annual compounded sales
growth.
(3) Brand strength

From airlines, through banking and newspapers, to telecommunications, there are plenty of brands with superior
name-recognition, but inferior financial performance.
Strong brands are well-known. Successful brands offer something differentiated; product, design, image. Winning
brands create affinity, an attachment with the customer either emotional or logical, they are loved.
Brand depends on company’s industry, for e.g. there are Apple and LV fans, but not necessarily Air France, Delta or
HSBC.
Differentiation and customer attachment allow for premium pricing and potentially market share gains (strong
correlation).
Heritage and brands, which improve with age
o E.g. Cartier, Ray Ban legacies are impossible to replicate and no amount of capital can reproduce such
history;
o Intertwining with specific geographies (e.g. Cognac, swiss chocolate, goods from Italy and France as higher
quality);
Trust and consistency brand = promise, implicit guarantee of quality or characteristics
o E.g. McDonald’s – inexpensive food of consistent quality delivered quickly in a clean environment.
The danger of newness Nintendo founded in 1889 and then producing games in 1977, was overtaken by Microsoft
Xbox and Sony PlayStation in 2000s superior innovation from competitors diminished brand appeal.
o Brands are more vulnerable when novelty and fast-changing technologies play a large role in benefits they
offer innovation-driven vulnerability (e.g. fast-changing world of fashion).
Scale advantage scale is advantageous in marketing and distribution (e.g. Estée Lauder and L’Oréal large market
shares are associated with high margins and capacity to spend on advertising and promotion.
o Advertising Nike;
o Distribution grocery stores selling Coca-Cola.
Using a powerful brand to drive growth
o Brand power can be enhanced through innovations and extensions;

o With creativity and advertising strong brands can expand to new products and categories easier;
o Brands considered strong status symbols often offer significant innovation leadership (e.g. luxury brands
gliding from handbag to perfumes or sunglasses) but too many products can dilute the appeal Pierre
Cardin, initially a high-end fashion brand, by licensing its brand out to products as diverse as cigarettes or
pens ended up diluting and dimming its brand.
Portfolio companies many companies boast diverse portfolio of brands (e.g. P&G, Unilever).
o Generally a portfolio of personal care products or luxury brands is superior to a portfolio of food brands.
o Diversified portfolio offers several advantages:
Some products struggle, while others absorb the loss and buy time to enable needed corrections;
Brand diversity can contribute scale that pays off in more effective advertising and promotion,
R&D and distribution;
Combination of scale and brand diversity can also lead to attractive acquisition
opportunities, especially to buy smaller upstarts. It pays off by: adding growth, combating
competitors and getting edge in research, innovation and distribution capabilities;
On the downside, managing a portfolio of brands requires wider skills set which can obscure
corporate focus and stretch management too thin. Resource stewardship is necessary to assure
most effective deployment across various lines.
Important to consider longevity. Investigate if the brand durable? brands that can retain preferred status for
decades if they have something special.
CASE STUDY – Diageo

1997 merger of Guinness and Grand Metropolitan, incredible portfolio of brands with remarkable and enviable
heritage of alcohol brands.
Stories of deep heritage, savvy marketing drive huge brand equity enabling premium pricing and strong profitability
for e.g. Scotch whisky Diageo accounts for 1/3 of emerging markets revenue; competitive advantage due to
unrivalled international history and $2.5 annually on advertising market share in premium Scotch approaching
50% = combination of heritage, strong brand positioning and high barriers to entry.
Wide spectrum of price points and extensive range of categories.
High gross margin of 60%, attractive operating margins of 30%.
(4) Market share gainers propensity to win market share from competitors
This type of growth is isolated from an overall market growth and hence is less dependent on macroeconomics.
Market share gainers reinforce competitive advantages based on scale (e.g. largest R&D budgets).
Halo effect most stakeholders (suppliers, distributors, employees) prefer to play on the winning team.
Exceptions to preferring consistent market share gains (especially in the short term)
o Company facing rapidly increasing costs should raise prices ahead of its competitors;
o Generally do not sacrifice gross margin for market share, unless you are a low cost producer because it has
an impact on the brand perception;
o Acquire healthy, high CLV customers, for e.g. in banking you can increase market share by lowering credit
quality standards and in insurance business by more relaxed underwriting. However, consequences of such
behavior may be dire as 2008 crisis has shown.
CASE STUDY – Fielmann

Founded its first optical store in 1972.
He pursued a strategy of selling fancier glasses at a lower price point forgoing high margins to gain market share.
Fielmann leveraged growth to backward integrate.
Overall affordable prices, savvy marketing and retail integration enabled him to establish market dominance.
Today Fielmann’s market share exceeds 50%, but shockingly he sells this volume through only 5% of the store base.
Scale and integration enables him to achieve a unit cost 75% cheaper than competitors.
Additionally, the company exemplifies a strong labor market leadership. It hires qualitied staff through its own optical
training academy of ~3,000 eye care professionals per year amounting to ~40% industry apprentices.

COST
(5) Low-price plus combines low pricing with protection against the competitive vulnerability it creates.
Examples: IKEA, Inditex, Costco.
Forging price-led model into a brand reputation.
Success depends on:
o Degree of product differentiation, but also standardization (e.g. IKEA furnishing)
o Scale is essential. Necessary to obtain thousands of inputs from around the world coordinated in a complex
fashion at a considerable cost model depends on:
Continuous and rapid responses to shifting consumer preferences;
Having control of the supply chain;
Managing inventory effectively;
Deftness in distribution;
As technology and supply chain automation commoditizes, these business models may become vulnerable.
Low-cost squared several cost-saving small steps
o Construct a business model, organization and culture that drives low cost in each step of every process
throughout the operation. Depth of cost consciousness adds protection that ordinary cost-minimization
tactics do not.
o For e.g. Costco – cheap building, low-rent, lighting, shelving, only cash. Aggregate savings are significant
and enable to offer the lowest price.
Banks – some low cost winners:
o Banking combines many unfavorable elements: commodity products, high leverage, regulation,
government support, cyclicality, gross margins are expressed by net interest margin, the difference between
the cost of funds and priced charged for funds, which is determined by uncontrollable macroeconomic
conditions and credit risk.
o Hidden cost loan losses sometimes take years to manifest so banks can achieve high net interest margin
as well as high profits, by being imprudent.
o Examples: Wells Fargo in the US and Svenska Handelsbanken in Europe.
Due to their strong balance sheets, they can obtain cheap capital from deposits and unsecured
bonds.
They make high quality loans with demonstrably low default risks.
Combined with operating costs, a bank can deliver good returns with lower net interest margin.
CASE STUDY – Ryanair

Lowest-cost airline substantial cost advantage, Ryanair’s unit cost is around half of other rivals such as Norwegian
or Air Berlin.
Low-cost strategy based:
o Extreme operating efficiency, such as: airport landing fees by getting concessions;
o Shrew fleet acquisition buying good airplanes for cheap
Bulk purchasing strategy yields volume rebates from manufactures and facilitates staffing an in-
house maintenance crew, which is cheaper than alternatives.
o Ideas to cut costs by charging for: food, luggage and airport check-in, discarding frequent-flier programs,
not using air bridges (+ free marketing from e.g. charging for toilets).
(6) Cost to replicate reverse thinking – what it would take for a newcomer to replicate the business and remove a
competitive advantage of its peers.
Two examples:
o In liquor business, white spirits (vodka, gin) are more at risk than brown spirits (cognac, whisky) because
they require less aging and thus its harder to build a credible portfolio.
o In aircraft engine manufacturing years of R&D have enabled a development of proprietary technology which
is hard to match for startups.
CASE STUDY – Experian

Provider of consumer credit data collected over a very long period.
It has completed multiple acquisitions to enhance its data portfolio and to leverage core assets, like data analytics.
Achieved a 6% CAGR sales growth and improved its operating margins from 20% to 27%.

OPERATIONS
(7) Good Management

Good managers are disciplined stewards because they:
o Focus on organic growth instead of “transformational” (often value-destructive) acquisitions.
o They are prudent about the balance sheet and counter-cyclical investment. Exceptional managers
minimize borrowing and turn a recession into advantage (e.g. H&M during last recession accelerated store
roll-out to take advantage of lower rents and better locations).
Good managers are independent, long-term thinkers:
o Handelsbanken – Swedish bank – implemented decentralized management structure and profit-sharing plan
rather than banker bonuses. It embraced risk aversion that discourages proprietary trading. Because of that
it became a supplier of capital during the financial crisis of 2008.
o Rolls-Royce – vision to sell more engines and generate recurring revenue through TotalCare, ongoing service
where price is based on engine’s hours in operations.
o Atlas Copco perceiving a threat from potential low-cost Chinese manufacturers in compressor business,
established its own low-end compressor business in China gaining an accurate knowledge of the upstarts to
better outflank them.
Super star award-winning CEOs usually under-perform low profile is better.
People matter developing good executives, for e.g. through rotational programs.
Good management is candid halo effect is dangerous.
(8) Innovation dominance companies with high gross margins have more to invest in R&D, A&P and distribution.
Such companies can invest more than their rivals, forge a virtuous cycle of growth. More spending drives revenues at
high gross margins that spins off more investable resources.
Innovation culture innovation dominance can facilitate both volume and pricing power.
o Even small innovations may matter, for e.g. offering the same product, but in smaller packages can expand
occasions of use (e.g. travel size);
o It is usually easier to price higher and get better margins on new rather than old products;
New products can attract price mix, new customers and drive volume;
o Innovation must be profitable to make innovation dominance attractive. Not all innovation makes
business better, it may lead to margin decline (when R&D is more expensive than gain from incremental
sales) or when a company cannibalizes its own products.
o To create value innovation must: a) increase volume or b) induced customers to switch from less to more
profitable company offerings e.g. in consumer goods is premiumization – charging higher price for social
status or health advantages.
o In markets where consumers are more cost conscious or defined primarily by taste benefits volume gains
are often a better target for innovation:
Products with clearly defined stand-alone taste benefits are harder to trade up (e.g. cereal, soft
drinks or candy bar – there are no premium brand of Corn Flakes, Kit-Kat etc. because it is hard
to persuade customers of merits of new and improved version).
There innovation is mostly focused on packaging or completely new flavors.
o For corporate consumers benefits from innovation need to be more tangible, e.g. appliances that slash energy
costs. They are usually risk averse so incremental improvements are usually easier to sell than revolutionary
innovations.
o Always question how sustainable is the innovation culture?
R&D led innovation
o Important to classify precisely R&D spending to compare it between companies.
o R&D can be (but does not have to be) an indicator of competitive edge, e.g. EssilorLuxottica accounts for
75% of total lens industry R&D spend.
o Incremental innovation tends to produce more predictable revenue growth
Better customer reaction annual 5% price increases become a routine, while abrupt price
increases by a company with no track record of improvements provoke critical customer scrutiny
about price-value mix.
(9) Forward integrators

Types of forward integration:
o Store ownership (e.g. LVMH expansion)

o Franchising (e.g. Marriott and Holiday Inn)
Franchise business model provides growth funded by a third party (franchisees) theoretically
infinite returns;
Ultimate expression of brand power – franchisees pay fees for the right to use a brand the fee
level is justified by the economic power of the brand;
Holiday Inn – franchisees pay 5% of revenues in exchange for the brand and access to branded
firm’s central booking system result is a higher level of revenue per available room;
Revenue based franchise fee adds predictability to franchisor’s returns as revenue is more stable
than net income.
Two key characteristics:
• Powerful business model to generate returns for the third party after fees to brand owner
• Minimum scale to have an infrastructure to support a franchise system
o Licensing
o Internet selling (e-tailing) (e.g. Nike e-commerce sales)
Two conditions to successfully integrate online and offline sales:
• Powerful brand
• Logistics infrastructure and capabilities
Online sales can be enhanced through good store presence and customer experience (e.g.
Nespresso or Apple)
Typically most successful integrators are powerful brands.
Costs: incremental capital requirements and added complexity.
Strategic value:
o Forward integration gives companies more influence over customer experience;
o Can strengthen position vs. competitors since selling and promoting products in the right location cements
brand and reputation (e.g. Fifth Avenue in NYC);
o Forward integration can ease entry into new markets. However, dependence on partners is dangerous,
especially in emerging markets. Companies which take time to build their own operations from scratch are
more likely to succeed than those who are at mercy of third parties;
o Can help build scale among stakeholders (e.g. Luxottica has bargaining position with other brands thanks
to its ownership of Sunglass Hut retail chain).
CASE STUDY – Luxottica

Founded in 1961 as a manufacturer of components for an Italian optical industry.
Currently owns a portfolio of global brands, such as Oakley or Ray-ban and licensed brands, like Armani.
Example of a successful forward integration throughout the value chain which increases profitability.
Forward integration in retail is not always attractive as it tends to increase fixed costs base, impairing the need for
flexibility for weak or volatile brands.
(10) Global capabilities and leadership ability to successfully enter foreign markets
Global leadership refers to product differentiation and business model rather than scale.
Global leadership is an important consideration because:
o It is unsafe to assume that even most powerful domestic companies will remain dominant if a superior
foreign competitor enters (e.g. disruption of Spanish and UK grocery markets by Germany discounters);
o Ability to expand can drive revenue growth (e.g. Assa Abloy, Atlas Copco) requires adaptability to local
tastes, cultures and an ability to solve logistical challenges (e.g. Yum brands – KFC entering Chinese market).
Often necessary to employ trial and error strategy.
CASE STUDY – Inditex

Founded in 1975 based on an idea of providing latest fashion at an affordable price.
In 2014, it generated $20b of sales from ~6,600 stores, 81% outside of Spain.
Consistently outperforms its peers because of a unique “demand pull” model and tight value chain control.
Compounded annual sales growth of 15% since 2000.
Its primary sources of competitive advantage are:
o Lean inventory managmenet, small batches based on bestsellers;
o Local sourcing from Spain;
o Short design lead time (4 weeks) and thus fast response to market trends;

o High full price sales (80% vs. 65% market) – not relying as heavily on discounts;
o Premium store locations and expectations to be profitable on stand-alone basis.
(11) Corporate culture core set of common values that drive success
There are multiple ways a good corporate culture can be exemplified:
o Cost conscious for low-cost providers;
o Scientific curiosity for research-driven firms;
o Team spirit and collaboration for cutting-edge tech startups.
To identify company’s priorities, norms and values ask suppliers, customers and former employees
Key characteristic:
o Trustworthiness honesty and integrity;
Common example: handling bad news by being open and frank.
o Long-term mindset forward looking vision and value creation;
Thinking about long-term allocation of capital to organic CapEx, R&D and A&P rather than
hitting short-term earnings goals prioritizing ROIC.
o Good execution timely execution and ability to meet deadlines;
Usually less “accident” prone;
Knowledgeable about their markets.
o Self-perpetuation
Recruitment based on hiring people with personalities that fit an associated culture.
Family-owned businesses tend to have a particularly good corporate culture.

These Notes Are A Synthesis of Ideas Presented in The Following Books

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These Notes Are A Synthesis of Ideas Presented in The Following Books

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These notes are a synthesis of ideas presented in the following books:

“Corporate Valuation Theory, Evidence and Practice” by Holthausen and Zmijewski

ASSESSING THE COMPETITIVE ADVANTAGE

ALLOCATING CAPITAL TO DRIVE VALUE

LINKING REVENUE GROWTH AND CAPITAL ALLOCATION

ANALYZING PATTERNS OF SUCCESSFUL COMPANIES

By Michal Kolakowski – June 2020 1

ASSESSING THE COMPETITIVE ADVANTAGE

Sources of competitive advantage:

By Michal Kolakowski – June 2020 2

By Michal Kolakowski – June 2020 3

By Michal Kolakowski – June 2020 4

Examples of capabilities needed to pursue a differentiation strategy9:

Examples of capabilities needed to pursue a cost leadership strategy10:

Factors determining sustainability of the competitive advantage 11:

Competitive advantage Challenge Example

By Michal Kolakowski – June 2020 5

Steps in the financial ratio analysis:12

Three most important ratios are ROIC, ROA and ROE13

Adjustments to correctly calculate ROIC:

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + (1 – Income Tax Rate for Interest) ∗ Interest Expense

The return on capital (ROIC) is driven by three elements:15

By Michal Kolakowski – June 2020 6

Working capital (current assets – current liabilities)

Working capital ratios:

Cost of working capital:

𝐼𝑛𝑐𝑜𝑚𝑒 𝑡𝑜 𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 Net Income – Preferred dividends

By Michal Kolakowski – June 2020 7

Disaggregating ROE (unlevered) Formula

ROA Unlevered Profit Margin * Asset Utilization

Unlevered Profit Margin 1 - ALL COSTS + INTEREST INCOME

Asset Utilization 1 / SUM OF RATIOS BELOW

Financial Leverage Factor 1 + SUM OF RATIOS BELOW

By Michal Kolakowski – June 2020 8

Adjustments to correctly calculate ROA:

Adjusting Ratios for Excess Assets: 21

ROA = Unlevered Profit Margin x Asset Utilization

By Michal Kolakowski – June 2020 9

Issues to consider when calculating ratios:22

Think carefully about minimizing expenses:

Always do a per unit analysis:24

By Michal Kolakowski – June 2020 10

Financial Leverage Ratios

Debt is sometimes difficult to define and measure for two reasons:27

By Michal Kolakowski – June 2020 11

Concluding remarks about the competitive advantage:

By Michal Kolakowski – June 2020 12

Capital expenditures (CapEx): 30

Investments in R&D, advertising and promotion (A&P): 31

Mergers and acquisitions (M&A):32

Dividends and buybacks:

By Michal Kolakowski – June 2020 13

Key drivers of ROIC:33

ROIC varies significantly across industries:34

By Michal Kolakowski – June 2020 14

Persistence of ROIC - patterns across industries:

Trending down Persistently low Cyclical Persistently Trending Up Persistently

Gaining market share:36

By Michal Kolakowski – June 2020 15

By Michal Kolakowski – June 2020 16

VALUE TYPE OF GROWTH RATIONALE

It is important to recognize cyclicality

Cyclical markets pose an analytical