FRANCHISE VALUATION UNDER Q-TYPE COMPETITION

In the two-phase growth model, we assumed that the firm with 12.4% growth (see Exhibit 3.8), transitioned after 10 years to a more stable 7.4% growth rate. This model is generally intended to reflect an initial span of growth and prosperity followed by a second-phase regression to a competitive equilibrium. This terminal stage can be construed as the period when sales growth stabilizes but the company's earnings continue to change as the pricing margin moves toward some competitive equilibrium. This margin-equilibrating process can usefully be described in terms of the ratio of asset replacement costs to the company's economic book value, B, and is related to Tobin's q.⁵

The valuation impact of this terminal-phase effect will depend totally on the nature of the company's business and its long-term competitive posture. Some companies will be positioned to gain from post-growth margin expansion. For some businesses, growth itself builds a relatively unassailable efficiency of scale with distinct organizational, distributional, and technological advantages. Patent protection and/or extraordinary brand acceptance may assure franchise-level margins for years to come. Leading-edge products may themselves act as germinators for subsequent generations of even more advanced products. For such fortunate companies, potential competitor's cost of building a new enterprise and comparable revenue stream might far exceed the existing firm's economic book value. In this case, the ratio, Q, of the competitive capital costs to B might be far greater than one. Investors in such companies may look forward to a future period of sustained high sales with margins that are maintained or even enhanced. At this point, the company begins to enjoy a “franchise ride” and the patient investor will finally be rewarded with the significant cash returns that formed the foundation for the value ascribed to the company at the outset.

For less fortunate growth companies, barriers to entry will indeed become porous over time. In this case, new technologies and efficiencies may offer competitors a Q value that is much less than one. In this case, the existing firm's high franchise margins will be vulnerable to erosion as the firm attempts to compete with lower prices. Earlier extraordinary earnings will be subject to the gravitational pull of commoditization and the P/E reduction will result from this “franchise slide.”

Inevitably, large, technologically proficient, well-capitalized competitors lurk in the shadows of even the greatest franchise, even if the competitive Q is greater than one. Theoretically, such competitors will be eager to replicate a company's products and services provided their return offers a modest spread over their cost of capital. That is, the new business will be attractive if the competitor's cost of capital is Q times the original firm's cost of capital (that is, Qk) and the corresponding return on equity is greater than Qk. This Q-type competition implies that the original firm's premium pricing could be so adversely impacted that its initially high ROE would be eroded down towards the competitor's Qk. This situation raises questions about many two-phase growth models that assume the terminal earnings level can be sustained in perpetuity, even when high initial growth would elevate the ROEs to the point of attracting sufficient Q-type competition to lower all pricing margins.⁶