Value Creation Part 2

Welcome back to Part 2 of the Value Creation series. If you haven’t checked out Part 1, then go check it out and meet me back here. To provide some quick background, I am reviewing Professor Aswath Damodaran’s four key points on how companies can create value for shareholders.  

 

In Part 1, I discussed the first two points:

 

  • Changing Cash Flows From Existing Assets
  • Increase Value From Expected Growth

 

We looked at how companies like eBay created shareholder value by spinning off a more successful venture, which was PayPal. We then analyzed how much value the launch of the iPhone provided Apple shareholders, as well as key M&A activity that Disney underwent in the 2000s, providing shareholders with enormous returns.

 

Without further ado, let’s move on to the third point.

 

3. Lengthening the Growth Period by Creating Or Augmenting Competitive Advantages

Build On Existing Competitive Advantages

Brand Name

Many companies’ largest strength is simply their brand name. Coca-Cola is the first business that comes to mind here. Actually, by the brand being the first example that popped into my head, it already proves how strong the brand name really is. Some brands are so popular ingrained in our minds that they actually dominate the identity of the product.

 

For example:

 

  • Kleenex = tissues
  • Band aid = bandages
  • Google = web search
  • Chapstick = lip balm
  • Post-it = sticky note
  • Coke = sweet soda beverage (At least, for everyone in the South)

 

And the list goes on evermore. But like empires, powerful brands aren’t built in a day. They take decades of marketing and advertising to get to this point. Not to mention the obvious factor: the product needs to be great.

 

Brand Protection

After an amazing brand is created, it must be defended. Sometimes the defense of a brand can be harder than creating one. Remaining top dog in people’s minds is not a simple thing to do, as I am sure many marketers will tell you.

 

Good management in a company will know that they should do all they can to protect the brand that pays their salary. Let’s continue on using Coca-Cola as an example.

 

 

In the past couple of decades, the Coca-Cola company has been the source of criticism in some outlets for producing a beverage that is quite unhealthy. Their drinks have been linked to terrible diseases like obesity and diabetes; but this is not exactly groundbreaking news.

 

However, this controversy has really unaffected the company on the whole. Coca-Cola is a well-diversified company at this point in the corporate life-cycle and owns many brands of beverages, with some of them being more “healthy” options.

 

Plus, at this point the brand is so powerful, it is almost too big to fail. Coca-Cola has done an excellent job of marketing their brand in association with good times and happiness. So good, in fact, that nearly 80% of the company’s profits are likely from the brand name alone!

 

After all, who doesn’t want a sweet drink once in a while?

 

Find New Competitive Advantages

Switching Costs

Imagine I just told you that your bank magically foreclosed, and you now had to switch to a new institution. How big of a pain would that be?

 

You would have to open a new account at a new bank, transfer all your money to that new account, get with HR at work to ensure your direct deposit goes to the new account, get a new debit card… I think you get the picture.

 

In this regard, certain banks, insurance companies, and other financial institutions benefit from the switching costs advantage. Nobody enjoys the chore of opening new accounts and talking to more people!

 

Companies that are able to understand this phenomenon will benefit from trying to implement it into their business model. In order to make this work, you want the barrier to entry to be low, but the hurdle to exit to be painful. This is difficult to do, but can be done by having one of the two business models below:

 

  • Decent business: offer an annoyingly necessary product
  • Best Business: offer a sticky product not found elsewhere 

 

The decent businesses are ones that offer products that are necessary to have, but are a pain to leave because of fees. Think of your recurring payments every month (either in or out): insurances, banks, cable/internet, etc. These companies are offering necessities, usually with contractual obligations. They make it a colossal pain to switch to another service for those just trying to save $20 a month.

 

Best to stick with them rather than pay the cancellation fee.

 

 

The best businesses are ones that offer a sticky product not found elsewhere. These tend to be tech companies that offer subscription business models. Think products like Adobe, Autodesk, or even Microsoft Office. These are all fantastic products that have widespread adoption that are used in many companies/governments, and are not easily replicated. 

 

All of these companies had previously offered their product as a one-time purchase. However, they quickly realized that being able to retain their customers for a small monthly fee would provide more stable sources of revenue, thus creating more value for shareholders.

 

Having a sticky product with recurring revenue is the far better option for both consumers and stockholders.

 

Cost Advantages

Companies that can find a way to lower their costs below that of their competitors will always be more beneficial to customers. The key here is being able to cut costs, but still being able to come up with free cash flow at the same time.

 

This usually means that the business has pricing power over its competitors. This is what makes or breaks commodity companies. 

 

Here’s an example:

 

If you operate an oil rig that only costs $30 to drill for a barrel of oil, but all your competitors are paying $50 to drill, then you have a $20 cost advantage over them. This advantage is even more significant if the price per barrel were to fall to $40. 

 

 

With the cost advantage, your company would still be making a profit, while your competitors are left scrambling to cut costs or acquire debt.

 

The trick here is to gain the cost advantage and keep it for as long as possible. This can lead to cut-throat price wars, but in the end, if your company can be the lowest-cost producer, you will be the only one left standing.

 

4. Lowering The Cost of Capital

Reducing The Operating Risk in Investments/Assets

Outsourcing

If a certain department or division of a company can be effectively outsourced (with no moral hazards), then why not do it? Effective outsourcing can allow businesses to focus what they do best and outsource the rest to someone else that can do it better.

 

Reduce Leverage

Reducing or eliminating debt is a sure-fire way to increase shareholder value. When a company goes bankrupt, the lien holders are the first ones to get their money back, not stockholders. 

 

By subtracting the debt, this means that you’re ownership is that much greater. Personally, I prefer to look at companies that have zero net debt, as that just means the company is a far less risky bet.

 

Flexible Wages and Cost Structure

COVID forced many of us to work from home, or at least use a hybrid model. This is likely to be the norm for most companies going forward. 

 

Both companies and employees benefit from flexible working. Companies are going to require less office space, which will cut down on real estate costs. The employee benefits from not having to commute to work every morning, and getting to work in their pajamas all day!

 

 

This new work structure will most likely have companies and employees feed more into the gig economy. This will also allow companies to be able to offer employees a more flexible salary or payment options.

 

I truly believe that the new remote/hybrid working environment is going to be a net benefit to almost everyone. But the most important benefactor is one you probably haven’t even thought about: the environment.

 

Think about it. Fewer cars commuting to work every day will eliminate a lot of traffic and pollution. Less office spaces in urban areas means we can build more parks and green spaces in order to revitalize our environment. 

 

Enhancing Current Products

Make the Product or Service Less Discretionary

I can think of one product over the last 20 years that has gone from barely used, to widely adopted: the cell phone.

 

Not only did the cell phone become the norm, we rapidly created new innovations on the cell phone by turning them into smartphones. 20 years ago, you really didn’t need a cell phone. You could get around and do things without it just fine.

 

Fast forward to today, and I can barely function without my cell phone. I use it for directions, music, reading, texting, etc. This widespread adoption of technology benefited many companies in lots of industries; telecommunication giants like Verizon and AT&T, phone manufacturers like Apple, semiconductor companies for the processors, the list goes on.

 

Changing Product Characteristics

Making a product more user friendly will only delight customers. Simply upgrading a product to a new model or even just making it look more appealing can increase sales.

 

More Effective Advertising

As mentioned above, marketing and advertising are enormous investments for a lot of businesses. Establishing a new marketing campaign can breathe new life into a brand or product. 

 

Remember a few years back when IHOP announced they were changing their name to IHOB? 

 

 

This stunt sent the internet ablaze. It obviously didn’t actually happen, but this campaign actually saw IHOP see some renewed attention and increased revenues for a while.

 

Changing The Financing Composition

Match Debt to Assets 

Normally, companies operate with a “normal” debt to assets ratio. Sometimes they can be over or under their target. By making a simple tweak to this, management can create more value for shareholders.

 

For example, there’s a company that currently has no debt, but normally operates at a 0.5 D/A ratio. Say that this company wants to acquire another firm, but it doesn’t have enough cash on hand. 

 

Since the company currently has no debt and normally operates at a 0.5 D/A level, this would allow them to lever up a bit in order to make the acquisition. 

 

Conclusion 

Finding quality businesses to invest in is important. What’s even more important is that you are able to understand how that business can enhance your investment by creating value.

 

If a company is able to repeatedly create value year after year, that is the sign of a high-quality compounder that you should investigate further. A lot of these businesses are well-known and fully priced, so the hardest part (for me anyway) is maintaining discipline in valuation.