The Dream Machine: Competitive Advantage and the “Value” of a Company

Imagine you own the only machine (and irreplicable) in the world that manufactures product X. Demand for X is virtually infinite, so you almost certainly know all your inventory will be sold with not much effort. And in cash. As the product is so demanded, you don’t even need a salesforce to sell it. But the best is yet to come: input costs are nearly zero because you own a vertically integrated business. Ah, and there are no taxes as you are rebuilding the world and no government has been structured so far. Isn’t it the perfect business? It’s the virtually 100% net margin business with no working capital and little PP&E. Indeed. Although, when valuing it, I bet you will not get much above the risk free rate (Rf). Check the example below:

Dream Machine Example

I have assumed you haven’t exerted your monopoly power to emanate your pricing power for the sake of simplicity (although a sustainable pricing power of X% per year would still be sufficient for the price tagging example, we just need a fixed number). Suppose the available money base do not support price hikes or simply that people do not accept prices higher than 1, otherwise they come and destroy your dream machine.

So here is the key issue: how would a potential buyer agree to pay more than the 850 price tag for your company? He would have to either:

  • Increase free cash flow – (a) if he under-invest in maintenance of the machine, which would affect its future free cash flow; not that smart! or (b) if he was fortunate enough to be able to replicate the irreplicable dream machine, but that would require R&D investment and expansion CAPEX which can not be estimated today, so we will ignore it. Moreover, input costs are already 0 so he wouldn’t benefit from scale, but rather increase the available cash at the end of the period
  • Accept a lower rate of return – pretty much what we are seeing in today’s global equity market

So what is the takeaway? Yes, competitive advantages (moats) are what we look for in a company, but the perfect company doesn’t exist and if it did, it was likely priced to perfection and thus shouldn’t be a great investment, unless you can manage to increase its value over time. The perfect company has little “investment value”.The marginal buyer can’t bid it up unless he accepts a rate of return lower than risk free – by the way, why work if you are already able to earn Rf?! Thus, addressing what are the moats in place and how to sustain those in the long run are of utmost importance, but understanding how can a company possibly expand the existing moats or even create new ones (i.e., leading indicators to the increased long-term free cash flow) is what analysts should fathom.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s