Competitive advantage period (CAP) --- Part 2

Competitive advantage period (CAP) is the time during which a company is expected to generate returns on incremental investment that exceed its cost of capital. Economic theory suggests that competitive forces will drive returns down to the cost of capital over time. If a company earns above market required returns, it will attract competitors that will accept lower returns, eventually driving industry returns lower. The notion of CAP has been around for some time; nonetheless, not much attention has been paid to it in the valuation literature. The equation can be summarized as follows:

Value = (NOPAT/WACC) + [I(R-WACC)CAP]/(WACC)(1+WACC)

where NOPAT = net operating profit after tax
WACC = weighted average cost of capital
I = annualized new investment in working and fixed capital
R = rate of return on invested capital
CAP = competitive advantage period

Rearranged, the formula reads:
CAP = {(Value*WACC-NOPAT)(1+WACC)}/I(R-WACC)

These formulas have some shortcomings that make them limiting in practice, but they demonstrate, with clarity, how CAP can be conceptualized in the valuation process. A company’s CAP is determined by a multitude of factors, both internal and external. On a company-specific basis, considerations such as industry structure, the company’s competitive position within that industry, and management strategies define the length of CAP. The structured competitive analysis framework set out by Michael Porter can be particularly useful in this assessment. Important external factors include government regulations and antitrust policies. CAP can also reflect investor psychology through implied optimism/pessimism regarding a firm’s prospects.

It is believed that the key determinants of CAP can be largely captured by a handful of drivers. The first is a company’s current return on invested capital. Generally speaking, higher ROIC businesses within an industry are the best positioned competitively (reflecting scale economies, entry barriers and management execution). As a result, it is often costlier and more time consuming for competitors to wrest competitive advantage away from high-return companies. Second is the rate of industry change. High returns in a rapidly changing sector (technology) are unlikely to be valued as generously as high returns in a more prosaic industry (beverages). The final driver is barriers to entry. High barriers to entry— or in some businesses, “lock-in” and increasing returns— are central to appreciating the sustainability of high returns on invested capital.