Sales Driven Franchise Value

This chapter is based on a monograph published in 1997 by the Research Foundation of the Institute of Chartered Financial Analysts. It has been placed out of chronological sequence because it provides a very compact description of the initial earnings-based approach to franchise value. It then proceeds to a more comprehensive framework by extending the FV concept to a sales-based approach. This broader sales-based framework has significant advantages for comparative analysis, especially in cross-border comparisons. The following chapter, Chapter 3, published in 1997 in the Financial Analysts Journal, serves as a comparison piece focusing on a more graphic characterization of various combinations of sales growth and margin compression.

In a series of earlier papers, published together in 1994, Leibowitz and Kogelman developed a franchise value (FV) approach for estimating the intrinsic value of a firm's equity. Although derived from the standard formulations of the dividend discount model (Williams 1938; Miller and Modigliani 1961; Gordon 1962), the FV approach has the powerful advantage of being a more general (as well as more intuitive) formulation. This greater generality is helpful in adopting the FV model to today's global capital markets, where capital availability is often not the scarce resource (Bernstein 1956; Solnik 1996). Moreover, the FV model's focus on the price/earnings ratio (P/E) allows exploration of many facets of this key market variable—a variable that is widely used in practice but all too little studied from an analytical viewpoint. Even though the original FV devel-

Reprinted from monograph published by the Research Foundation of the Institute of Chartered Financial Analysts, July 1997.

opment was based on the traditional earnings construct, it is an easy transformation to express the FV model in terms of net operating income, free cash flow, or other measures of economic value (Stewart 1991; Copeland, Koller, and Murrin 1994; Peterson and Peterson 1996). Because the earlier papers and much of current practice still follows the traditional earnings mode of analysis, this terminology will be retained here for purposes of consistency.

In this chapter, the purpose is to migrate from the return-on-investments FV model that formed the basis for the earlier work to a formulation that is based on the opportunity to generate sales—that is, a sales-driven franchise value. Although sales and investments are two sides of the same coin, it is a fairly major mental shift to view the opportunity for generating productive sales as the precursor and the ultimate motivation for investment (Rappaport 1986). This sales-driven context is especially productive in valuing multinational corporations. These firms have the size and reach to site production facilities anywhere in the world, resulting in a strong trend toward convergence in production efficiency. Increasingly, such megafirms are distinguished not by their production costs but by their distinctive approaches to specific markets. In other words, they create shareholder value through their sales-driven franchise.

The sales-driven FV model "looks through" the earnings to the more fundamental considerations of sales generated and net margins obtained. A key feature of the investment-driven FV approach is that it distinguishes between the current business and its future opportunities. In the sales-driven context, the net margin on the current level of sales is differentiated from the margin on new sales growth. This differentiation leads directly to the introduction of a simple, but powerful, concept—the franchise margin—to incorporate the capital costs required to generate these new sales.

The franchise margin has a number of important intuitive interpretations. First of all, it can be viewed as the present value added per dollar of annual sales. A second interpretation is that the franchise margin represents the excess profit that the company is able to extract from a given dollar of sales above and beyond that available to any well-financed, well-organized competitor who would be content to simply cover the cost of capital. This second interpretation can be especially relevant for a global market, where competitors with these characteristics are looming in the wings and would be able to field their products should any opportunity present itself. Moreover, in markets where cost-of-production efficiencies do not create any persistent benefits, the majority of the franchise margin will be derived from the company's ability to extract a better price per unit of sales. In such circumstances, the franchise margin becomes a good proxy for the pricing power of the firm's product in a given market. In this sense, the franchise margin truly represents the special value of a brand, a patent, a unique image, a protected distribution system, or some form of intellectual property that enables a company to extract an excess profit in a particular market (Treynor 1994; Smith and Parr 1994; Romer 1994).

One of the virtues of the sales-driven approach is that it shines a much brighter light on the fragility of a product franchise. In today's competitive environment, few products can count on long "franchise runs" with fully sustained profitability. At some point, the tariff barrier erodes, the patent expires, the distribution channel is penetrated, the competition is mobilized, or the fashions simply shift. Over time, virtually all products become vulnerable to commodity pricing by competitors who would be quite happy to earn only a marginal excess return. Even without direct visible competition, a firm may have to lower its pricing (and hence its margin) to blunt the implicit threat from phantom competitors (Statman 1984; Reilly 1997; Fisher 1996).

One way or another, the franchise runs out. When this occurs, sales may still continue to grow, but the margins earned must surely fall. Taken to the extreme, this margin compression will ultimately drive the franchise margin toward zero. And without a franchise margin, subsequent sales growth fails to add net present value and hence can have no further impact on the firm's valuation or its P/E. This effect can be surprisingly large— even for a highly robust franchise that lasts for many years. For instance, one example in this chapter shows how the prospective termination of a valuable franchise 20 years hence can pull a firm's current P/E from a lofty 22 down to less than 13. History has shown that franchise erosion of one form or another can spread beyond individual firms, sometimes with devastating effect on entire economic regions and their financial markets (Brown, Goetzmann, and Ross 1995). These fundamental issues of franchise limitations are much more clearly visible in a sales context than in the standard investment-based formulations with their emphasis on return on equity (ROE) estimation.

Another point of departure from Leibowitz and Kogelman is the focus on the price/sales ratio (P/S) as a particularly useful yardstick. As might be expected, the sales-driven orientation leads naturally to a greater role for the more "accounting neutral" P/S (Damodaran 1994; Fisher 1984; Barbee 1996). Moreover, P/S can sometimes supply better insights than P/E because of its more explicit treatment of any franchises embedded in the current business. Such franchises can have important implications for valuation and risk assessment, and they can also lead to a variety of paradoxical results. In a later section, an example is presented where an improvement in the current margin can lower a firm's P/E but at the same time raise its P/S. Thus, for a broad range of corporate situations, a variety of analytical and intuitional advantages favor the sales-driven approach relative to standard valuation methods and relative to the original investment-driven FV model. Figure 2.1 provides a summarized listing of these advantages.

With the sales-driven FV model, a firm's value depends on its ability (1) to sustain the pricing power required to achieve positive franchise margins on a significant portion of its sales and (2) to access new markets that can support a high level of sales growth. Thus, the sales-driven model emphasizes a corporation's ability to maintain an existing franchise, to create a new market for itself, or to successfully invade an established market. This competitive advantage in unearthing and attacking sizable markets distinguishes the highly valued firm that should trade at a high price/sales ratio (or a high

FIGURE 2.1 Summary of Features of Sales-Driven Franchise Model

Retains Benefits of Investment-Driven FV Model

Better Fit for Multinational Companies Facing Global Equilibrium of Production Costs

Sales/Margin Parameters More Intuitive and More Directly Estimable than ROEs

Places Market Opportunities as Central Driver of Investment and Value Creation

Relates New Market Opportunities to Existing Sales Level

Underscores Role of Pricing Power Segregates Product Margins from

Magnitude of Product Market Clearly Distinguishes between Sales Growth and Value Creation

Relates Sales Turnover and Capital Costs to Franchise Opportunity

Explicitly Accommodates Competitive Pressures on Future Margins Clarifies the End Game Scenarios Associated with the Termination of a "Franchise Run" Accommodates Phenomenon of Super-ROEs from Rapid Leveraging of Prior Investments into New Product Markets price/earnings ratio). In a world with ample capital, with great fungibility of that capital, and with financial markets that can bring capital quickly to bear wherever excess returns are available, it is no longer the capital, the retention of earnings, or the financial strength per se that is the key ingredient of success. These are not the scarce resources in this new regime. The scarce resource is that special edge that enables a firm to extract franchise pricing for a product that is broadly demanded.

One word of caution is appropriate at the outset. In the application of any equity valuation model, the analyst comes to a crossroads where a fundamental decision must be made. Even a properly estimated valuation model can quantify only the current business activity and the more visible prospects for the future. In theory, all such visible and/or probable opportunities can be incorporated in the valuation process. But any such analytical approach will fall short of capturing the full value represented by a dynamic, growing multinational corporation. Many facets of a vibrant organization—the proven ability to aggressively take advantage of previously unforeseen (and unforeseeable) opportunities, a determination to jettison or restructure deteriorating lines of business, a corporate culture that fosters productive innovation, and so forth—are difficult to fit into the confines of any precise model. At some point, the analyst must draw the line and define certain franchise opportunities as estimable and visible and relegate the remaining "hyperfranchise" possibilities to the realm of speculation and/or faith. To paraphrase Bernstein (1996), analyzing a firm's future is akin to assessing the value of a continually unfinished game in which the rules themselves drift on a tide of uncertainty. The purpose of this observation is to caution the analyst that the results of any equity valuation model should be viewed only as a first step in a truly comprehensive assessment of firm value. At the very most, the modeled result should be taken as delineating the region beyond which the analyst must rely on imagination and intuition.

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