Credit Suisse's Global Financial Strategies team has published an updated version of the report Measuring the Moat. The report assesses the magnitude and sustainability of value creation.
Below is a very brief summary.
Corporate managers seek to allocate resources so as to generate attractive long-term returns on investment. Investors search for stocks of companies that are mispriced relative to expectations for financial results embedded in the shares. In both cases, sustainable value creation is of prime interest.
What exactly is sustainable value creation?
We can think of it in two dimensions.
- The magnitude of returns in excess of the cost of capital that a company does, or will, generate.
Magnitude considers not only the return on investment but also how much a company can invest at a rate above the cost of capital. Growth only creates value when a company generates returns on investment that exceed the cost of capital.
- How long a company can earn returns in excess of the cost of capital.
This concept is also known as fade rate, competitive advantage period (CAP), value growth duration, and “T” in economic literature. Despite the unquestionable significance of the longevity dimension, researchers and investors give it insufficient attention.
How is sustainable value creation distinct from sustainable competitive advantage?
A company must have two characteristics to claim that it has a competitive advantage.
- It must generate, or have an ability to generate, returns in excess of the cost of capital.
- It must earn an economic return that is higher than the average of its competitors.
Sustainable value creation is rare, and sustainable competitive advantage is even rarer.
Creating value
Core to understanding sustainable value creation is a clear understanding of how a company creates shareholder value. A company’s ability to create value is a function of the strategies it pursues, its interaction with competitors, and how it deals with non-competitors.
Much of what companies discuss as strategy is not strategy at all. As Michael Porter emphasizes, strategy is different than aspirations, more than a particular action, and distinct from vision or values.
Further, Porter differentiates between operational effectiveness and strategic positioning. Operational effectiveness describes how well a company does the same activity as others. Strategic positioning focuses on how a company’s activities differ from those of its competitors. And where there are differences, there are trade-offs.
Adam Brandenburger and Harborne Stuart, professors of strategy, offer a very concrete and sound definition of how a firm adds value:
Value created = willingness-to-pay – opportunity cost
The equation basically says that the value a company creates is the difference between what it gets for its product or service and what it costs to produce that product (including the opportunity cost of capital). Understanding what each of the terms means is fundamental to appreciating the equation.
Imagine someone hands you a brand new tennis racket. Clearly, that is good. Now imagine that the same person starts withdrawing money from your bank account in small increments. The amount of money at which you are indifferent to having the racket or the cash is the definition of willingness to pay. If you can buy a product or service for less than your willingness to pay, you enjoy a consumer surplus.
The flip side describes opportunity cost. A firm takes some resource from its supplier. Opportunity cost is the cash amount that makes the supplier perceive the new situation (cash) as equivalent to the old situation (resource).
Brandenburger and Stuart define four strategies to create more value:
- increase the willingness to pay of your customers;
- reduce the willingness to pay of the customers of your competitors;
- reduce the opportunity cost of your suppliers;
- increase the opportunity cost of suppliers to your competitors.
There are three broad sources of added value: production advantages, consumer advantages, and external (e.g., government) factors.
Competition and Cooperation
How firms interact with one another plays an important role in shaping sustainable value creation.
You might assume that companies always evaluate the potential reactions of their competitors. But that is frequently not the case. During a roundtable discussion in the mid-1990s, for instance, the chief financial officer of International Paper revealed that his company considered basic economic conditions when weighing the decision to build a new paper facility. But he conceded the absence of a game theoretic approach: “What we never seem to factor in, however, is the response of our competitors. Who else is going to build a plant or machine at the same time?”
Not all business relationships are based on conflict. The role of co-evolution, or cooperation, in business must also be recognised. Sometimes companies outside the purview of a firm’s competitive set can heavily influence its value creation prospects.
Consider the example electric car manufacturers and the makers of charging stations. A consumer is more likely to purchase an electric vehicle when the number and quality of options for charging increases. And charging stations are more valuable if there are more electric vehicles on the road. Complementors make the added value pie bigger. Competitors fight over a fixed pie.
