Lesson 7 of 7
How long an advantage lasts
A return above the cost of capital is worth more the longer it can be expected to last. Ten years of filed returns show whether it is fading or holding.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- The value of an excess return depends on how many years it can be expected to last, not only on its size.
- Ten years of filed returns can show a fade towards the cost of capital, or a level that holds.
- Analysts call this stretch the competitive advantage period, or CAP, and it is an estimate, never a fact in the filing.
An excess return earned for one year and one earned for ten are not worth the same multiple of that year's profit, even at an identical rate. How long the return can be expected to last is a separate question from how large it is today. It has to be answered from a run of years, not from one.
Two returns on capital, over ten years
- A return that holds
- A return that fades
Show the numbers
| A return that holds | A return that fades | |
|---|---|---|
| Year 1 | 20% | 25% |
| Year 2 | 20% | 22% |
| Year 3 | 20% | 19.5% |
| Year 4 | 20% | 17.5% |
| Year 5 | 20% | 15.8% |
| Year 6 | 20% | 14.4% |
| Year 7 | 20% | 13.1% |
| Year 8 | 20% | 12% |
| Year 9 | 20% | 11% |
| Year 10 | 20% | 9% |
What the competitive advantage period is estimating
Mauboussin, Callahan and Majd call this stretch the competitive advantage period, or CAP. It is the number of years a company can be expected to earn a return above its cost of capital before competition brings it back down to that cost. It is not disclosed anywhere. It is inferred from how long a return has already held, from the industry's structure, and from how the return has moved so far.
Read the fade, not just the level
A return on capital that has held flat for ten years, including at least one difficult year, is a durable signal. The same level reached only in the last two years of a boom is a weaker one. A return that has already declined for several years in a row is a different signal, even if it is still above the cost of capital today. It is telling you the fade the CAP estimate is trying to guess at has already started.
Longer is worth more, at a falling rate
Greenwald, Kahn, Sonkin and van Biema argue that earnings power above the value of the assets lasts only where barriers to entry protect it. Without them, competition closes the gap, and growth adds nothing. The value of an excess return is the sum of every future year it survives, discounted back to today. That is why how long it lasts matters as much as how large it is in any single year.
Check yourself
A company has earned a return above its cost of capital for ten years, including one recession year, without it falling. What does that suggest about its competitive advantage period?
- Nothing, since ten years proves nothing
- It held through a full cycle, a stronger signal than a boom-only run
- The return is certain to hold for another ten years
Show the answer
Answer: B.
Ten years including a downturn is stronger evidence of durability than the same level reached only during favourable conditions, though it is still not a guarantee of what comes next.An excess return of $10 a year discounted at 10 percent is worth $37.91 over 5 years and $61.45 over 10 years. Why is the 10-year figure not exactly double?
- The arithmetic is wrong
- Each additional year is discounted more heavily than the one before it
- The excess return shrinks after year 5
Show the answer
Answer: B.
Discounting means a dollar further in the future is worth less today, so doubling the number of years adds less than double the present value.What does a competitive advantage period, or CAP, estimate?
- The exact number of years stated in the 10-K
- How many years a return above the cost of capital can be expected to last
- The company's total market value
Show the answer
Answer: B.
The CAP is an estimate, inferred from history and industry structure, of how long an excess return can persist before competition brings it back to the cost of capital.Sources
- Mauboussin, Callahan and Majd, "Measuring the Moat," Credit Suisse, 2016, on the competitive advantage period.
- Greenwald, Kahn, Sonkin and van Biema, Value Investing: From Graham to Buffett and Beyond, 2001, on asset value, earnings power value and the value of growth.
What this leaves out
- The ten-year fade and the return that holds are both illustrative curves; they model no company.
- The competitive advantage period is an estimate inferred from history and industry structure, never a number stated in a filing.
- The annuity example discounts at a single flat rate for simplicity; a real estimate might use a rate tied to the business's own cost of capital.
- Nothing here is advice about any security.