Competitive advantage period (CAP) --- Part 3

The CAP for the U.S. stock market, as a whole, is estimated to be between 10 and15 years. However, within that aggregate, individual company CAPs can vary from 0-2 years to over 20 years. As a general rule, companies with low multiples tend to have shorter CAPs. Alternatively, companies with high multiples typically have long CAPs.

For example, companies like Microsoft and Coca-Cola have CAPs well in excess of 20 years, demonstrating their perceived market dominance, the sustainability of high returns, and the market’s willingness to take the long view. If a substantial percentage of the value of acompany can be attributed to cash flows beyond a few years, it is difficult to argue persuasively that the market is short-term-oriented. In turn, it follows that the forecast periods used in most valuation models are not long enough.

It may be more important for the investor to try to quantify CAP than to pass judgment on its correctness. As noted earlier, the components of value are all expectational, and therefore must be considered relative to one another and against the expectations for the business overall. There are a number of ways of estimating CAP, but one of the most useful methods was developed by Al Rappaport. The technique is known as market-implied CAP (MICAP). Determination of the MICAP has a few steps.

First,the analyst needs a proxy for unbiased market expectations as the key input into a discounted cash flow model. Since, by definition, there is no value creation assumed after CAP, the model uses a perpetuity assumption (NOPATCAP/WACC) for the terminal value. Next, the length of the forecast horizon is stretched as many years as necessary to achieve the current stock price. This period is the company’s MICAP. Scrutiny of the MICAP determination process would correctly identify it as a circular exercise. That is, if a stock price increases without changes in cash flow expectations and/or risk, the MICAP will necessarily expand. This in no way weakens CAP’s value as an analytical tool. In fact, this tight link with valuation highlights the power of including CAP as a key tool in the analytic toolbag. For instance, a calculated MICAP can be compared to previous MICAPs for the same company, an average MICAP for the industry (if possible and appropriate), and the company’s historical cash-on-cash return on invested capital.