Bruce Greenwald on Valuing a Franchise: Pt. 4

So we’ve made it this far:

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The organic growth part is actually quite easy. Again this is increase in sales that requires very little new investment by the company – basically just increased demand. If we were investigating Home Depot, we might just look at same store sales growth. But in his examples, Greenwald often takes a macro approach, saying that this term is going to be GDP growth +/- some percent.

GDP growth might be ~4%. To this we might add (subtract) 1-2% if the company sells to wealthier (poorer) customers. Similarly we might add (subtract) 0.5-1% if the company sells services (goods).

OrganicGrowth = GDP +/- Rich vs. Poor +/- Services vs. Goods

I’m going to give IBM +0.5% for selling to wealthier clients (businesses), and an additional +0.5% for directing their business more and more to selling services. So…

OrganicGrowth = 4% + 0.5% + 0.5% = 5%

Sidebar: do all companies you evaluate get the tailwind of ~4% for organic growth? No – only companies with a real competitive advantage that creates barriers to entry. Otherwise, entry by new competitors will appear to meet increases in demand. For now, I’m assuming IBM has such an economic moat – but will need to verify that.

So, we know IBM is at a P/E of 10, or E/P of 10% and we’ve now found Organic Growth. Let’s fill in more of our expected return.

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And we’re storyboarding, remember? So let’s round to the nearest integer to make sure the brain stays with the big picture.

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I’m going to do something really lazy here for brevity. For marginal ROC I’m going to go to Morningstar and just grab IBM’s trailing twelve months accounting return on invested capital. It’s ~30%. I’m also going to just assume their cost of capital is ~10%. When Greenwald works an example, it’s clear he’s already read the 10-K and knows roughly what these numbers are. I do it backwards – making rough guesses first, then reading the 10-K to verify later.

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We finally have an estimate. ~17%. If we now crack the 10-K and find that all of our guesses at organic growth, return on capital, cash retention policy, etc. appear to be correct, should we go with it?

Hint: There’s an important element that’s always a part of NPV value investing that should also play a part in IRR value investing. Can you guess what it is?