- That is where the existence of a franchise is crucial.
- If there were no barriers to entry, then gains would be get competed away by additional competitors.
- So it is only growth behind those barriers that creates value.
When you look at growth, this is what you look at:
1. First is verify the franchise. If you don’t have a franchise, then growth is worth $0.
- Look at historical returns, share stability.
- Look for sustainable competitive advantages.
- You don’t look at a P/E ratio, you look at an earnings ratio.
- If you are paying 14x earnings, it is a 7% if that P/E ratio stays the same and the earnings stay the same. You pay 11 times, it is 9%. 8 times, then 12.5%.
- If it is a 8 times multiple, it is a 12.5% return.
- The dividend is 2.5% and you are buying back 5% in stock per year, you are getting 7.5% in your hot little hand.
- If dividends and buyback policies are stable, then what are you getting.
- There are not stable then you have to estimate what they will be over time.
- But you want to know what fraction of the earnings get distributed.
- So if 11 times multiple and they historically distribute a third of the earnings, 1/11 is a 9% and 1/3 of that is a 3% distribution.
4. What happens to the other 6%?
- That gets reinvested—there the critical thing about the value is how effective do they reinvest that money?
- So in growth stocks, capital allocation is critical.
- Because (mgt.) is typically keeping most of your money and you care about how effectively they are investing it.
Organic growth: Then certain companies get returns essentially without much investment--which is that if you own a franchise, even without conscious expansion, that franchise will sometimes grow. The incremental investment involved is negligible.