Thanks for the reply. I guess there is some confusion and that’s primarily because of its name . Let me clarify further. I am not taking competitive advantage period as an assumption in the above modelling works. This is a calculated field. First of all, there are many names of this period. MM calls it as competitive advantage period but more often refers it as market implied forecast period. His basic premise is that expectations investing starts with what we know, the stock price, and asks whether the expectations for the company’s financial performance implied by the stock price are justified.
Before we discuss it further, let me put here his response to an interview question by Motely Fool:
Q: The book also says, “Analysts typically choose a forecast period that is too short when they perform a discounted cash flow valuation.” Most forecast periods I’ve seen are five to 10 years before they calculate the terminal value. Can you explain how analysts should determine how long the forecast period should be?
A: This is interesting. Most DCF models use an explicit forecast horizon of five years. Some go out 10 years or more, but they tend to be rare. I think the five-year horizon is an outgrowth of the leveraged buyout models used in private equity. Five years may make sense for a private equity firm that has an explicit objective of exiting an investment in about five years. But just because we have five fingers on a hand, or because private equity firms hold investments for five years on average, does not have any relevance for properly modeling the economics of a public company.
The result is that investors have to allocate value in the continuing value estimate, often through using an unrealistic calculation of growth in perpetuity or multiples of earnings before taxes, depreciation, and amortization. The goal of a model is to represent reality, and this approach fails in that objective.
You determine the market-implied forecast period by using consensus estimates for free cash flow growth plus an appropriate continuing value, an estimate of the cost of capital, and seeing how many years are necessary to solve for today’s stock price. For example, in the case study we did on Domino’s Pizza we found that the market-implied forecast period was eight years.
Now if you read above answer by MM, it becomes clearer. In nutshell, this is not the period in which they will lose or maintain its competitive advantage, rather this is the number of years which the current stock price assumes that the company will have ROIC higher than WACC i.e. will have a period with competitive advantage. This is the period which an investor should project in future to do DCF calculations and beyond that period, terminal value calculations. Hope it’s clear.
Now, coming to your statement that if this period is 25 years or more, every company will be undervalued. Here is the proof why this isn’t the case.
Let’s take the example of Asian Paints. No one can argue that this company shouldn’t have competitive advantage for many years to come. However, the current stock price already has assumed this or rather it’s already factored in the price.
Below are the details of Asian Paints:
- Steady state value = 36, 275 Crs
- ROIC in 2023 = 31%
- Future state value = 380, 619 Crs
- Total value = 416, 894 Crs
- Competitive advantage period or market implied forecast period = 25+ years
- Value per share with margin of safety = 2173 which is lower than current price. That means its overvalued.
For more details, I would highly suggest you read his book, watch his YT videos and / or read his interviews. It will be super clear.
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