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Franchise
Value
A Modern Approach
to Security Analysis
MARTIN L. LEIBOWITZ
John Wiley & Sons, Inc.
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Praise for Franchise Value
“The arrival of Franchise Value could not be more timely for the practice of
security analysis. Who better to prepare us than Martin Leibowitz with his
nearly two decades of sage writings on the subject informed by his combined experiences as a serious quantitative researcher and a major-league
practitioner? Whether novice student or seasoned professional, the reader
is in for a treat. Bon appetit!”
—Robert C. Merton, 1997 Nobel Prize Laureate in Economics
“The franchise value model is a major advance beyond the traditional dividend discount model in the analysis of present and future company value.
In this volume Martin Leibowitz, one of its creators, presents the model
and many of its applications.”
—Harry M. Markowitz, 1990 Nobel Prize Laureate in Economics
“A bold investigation into the basis for common-stock valuation that will
challenge conventional thinking about such basic ideas as earnings and
growth.”
—Jack Treynor, Treynor Capital Management, Inc.
“Give Martin Leibowitz a problem and you may be sure the solution he
provides will be creative, profound, provocative, and durable. This lucid
solution to the puzzle of corporate valuation is no exception. Every investor, economist, accountant, and banker will gain from Leibowitz’s powerful insight, keen analysis, and profound understanding of the economic
process.”
—Peter L. Bernstein, author of Against the Gods
“Franchise Value untangles the knotty issues surrounding equity valuation
and growth. In moving beyond conventional approaches to security valuation, Marty Leibowitz brings exceptional clarity to drivers of company
value. The important insights in Franchise Value provide enormous practical benefit to all serious students of equity markets.”
—David F. Swensen, Chief Investment Officer, Yale University
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“Over the years, Marty Leibowitz has made many seminal contributions to
our understanding of capital markets and the management of risks in the
quest for return. In the world of equities, none rivals his development of
the concept of franchise value, and the legacy of the bubble, ‘anti-franchise
value’! This volume assembles this body of literature into a single volume,
which is essential reading and an essential reference volume for anyone
who cares about equity valuation.”
—Robert Arnott, Editor, Financial Analysts Journal
“Marty Leibowitz and his coauthor, Stanley Kogelman, produced an insightful series of papers that explored the complex relationship between
valuations (as measured by P/Es) and growth. This collection draws these
‘Franchise Value’ papers (as they came to be called) together for the first
time, and captures their multifaceted view of this complex topic. The papers ought to be required reading for serious students of equity valuation.”
—Professor Jay O. Light, Harvard Business School
“A treasure trove of profoundly important investment insights from one of
the most revered minds of our generation. Franchise Value is an outstanding book that is must reading for every investment professional on the
planet!”
—Robert L. Hagin, author of Investment Management:
Portfolio Diversification, Risk, and Timing—Fact and Fiction
“The price/earnings multiple is the most widely used and misused valuation metric in the investment community. Marty Leibowitz combines
sound theory and practical wisdom to demystify what really determines
P/E multiples. Most importantly, readers learn how to identify companies
that create franchise value by investing at above the cost of capital and
companies that grow but nonetheless destroy value. Security analysts, serious investors, and corporate executives will each find invaluable insights
and lessons in this splendid book.”
—Alfred Rappaport, Leonard Spacek Professor Emeritus,
Northwestern University
“In a career filled with earned accolades, Marty’s longtime work on franchise value has somehow remained an underappreciated part of his vast
contribution to investment theory and practice. Hopefully, these newly collected papers will remedy this situation.”
—Clifford S. Asness, Ph.D., Managing Principal,
AQR Capital Management
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Franchise
Value
A Modern Approach
to Security Analysis
MARTIN L. LEIBOWITZ
John Wiley & Sons, Inc.
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Copyright © 2004 by Martin L. Leibowitz. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in
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best efforts in preparing this book, they make no representations or warranties with respect
to the accuracy or completeness of the contents of this book and specifically disclaim any
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10 9 8 7 6 5 4 3 2 1
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To all my associates and coauthors, as well as to all the
portfolio managers, analysts, traders, and even competitors
in the financial community who were so generous in sharing
their thoughts, their concerns, and their enthusiasm with
the author over such a wonderful span of years
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Contents
CHAPTER 1
An Introduction to the Franchise Value Approach
1
CHAPTER 2
Sales-Driven Franchise Value
24
Reprinted from monograph published by the Research
Foundation of the Institute of Chartered Financial
Analysts, July 1997
CHAPTER 3
Franchise Margins and the Sales-Driven Franchise Value
76
Financial Analysts Journal, November/December 1997
(Received Graham & Dodd Scroll for 1997)
CHAPTER 4
Franchise Value and the Price/Earnings Ratio
98
with Stanley Kogelman
“Inside the P/E Ratio: The Franchise Factor,” Financial
Analysts Journal, November/December 1990
“Inside the P/E Ratio (Part II): The Franchise
Portfolio,” Salomon Brothers, January 1991
“A Franchise Factor Model for Spread Banking,”
Salomon Brothers, April 1991
“The Franchise Factor for Leveraged Firms,” Financial
Analysts Journal, November/December 1991
“Franchise Value and the Growth Process,” Financial
Analysts Journal, January/February 1992 (Received
Graham & Dodd Scroll)
“The Growth Illusion: The P/E ‘Cost’ of Earnings
Growth,” Salomon Brothers, April 1993 (Received
Graham & Dodd Scroll)
“Inflation-Adjusted ROEs: Strong Effects Even with
Low Inflation,” Journal of Investing, Winter 1993
vii
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CONTENTS
“Resolving the Equity Duration Paradox,” Financial
Analysts Journal, January/February 1993
“Theoretical Price/Earnings Ratios and Accounting
Variables,” Salomon Brothers, June 1992
CHAPTER 5
Franchise Valuation under Q-Type Competition
304
Financial Analysts Journal, November/December 1998
CHAPTER 6
P/E Forwards and Their Orbits
327
Financial Analysts Journal, May/June 1999
(Received Graham & Dodd Scroll for 1999)
CHAPTER 7
Franchise Labor
357
Financial Analysts Journal, March/April 2000
CHAPTER 8
Spread-Driven Dividend Discount Models
372
Financial Analysts Journal, November/December 2000
CHAPTER 9
The Levered P/E Ratio
403
Financial Analysts Journal, November/December 2002
CHAPTER 10
The Franchise Value Approach to the Leveraged Company
424
The Research Foundation of AIMR
CHAPTER 11
Retirement Planning and the Asset/Salary Ratio
446
with J. Benson Durham, P. Brett Hammond,
and Michael Heller
Innovations in Retirement Financing, University
of Pennsylvania Press
Notes
471
Index
487
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Acknowledgments
he author would like to first acknowledge the crucial role of Dr. Stanley
Kogelman, my partner in developing the Franchise Value concept, and
the coauthor of all the early papers.
A deep debt of thanks is also due to Dr. Frank Fabozzi, who first
broached the idea of publishing a comprehensive work covering all the
Franchise Value analyses.
Next, I would like to express my gratitude to all my other coauthors,
with special thanks to my associate, Dr. Brett Hammond, for his great help
in preparing the introductory chapter of this volume. There were many
other friends and colleagues whose assistance and guidance proved invaluable in the development and publication of these studies. The following individuals deserve particular mention in this regard: Edward Altman, John
Ameriks, Lawrence Bader, Peter L. Bernstein, Anthony Bova, Paul Davis,
Benson Durham, Hans Erikson, Scott Evans, James Farrell, Robert Ferguson, Eric Fisher, James Fleischmann, Ernest Froehboese, John Goldsberry,
Michael Granito, William Gray, Martin Gruber, Michael Heller, Michael
Howell, Leo Kamp, Harry Klaristenfeld, Kim Leibowitz, Eric Lindenberg,
Jack Meyer, Richard Michaud, Mary Ann Prevost, Steven Ross, Robert Salomon, James Scott, Katrina F. Sherrerd, David Shulman, Eric Sorensen,
Jack L. Treynor, Antoine Van Agtmael, William Van Harlow, Mark Warshawsky, Rosalie Wolf, and Yuewu Xu.
Without the professionalism and careful nurturing of my editor, Bill
Falloon, this book would never have come to fruition.
And finally, but hardly last, there is no way that the author can fully or
adequately express his thanks to his assistant, Celia Blancaflor, for her calm
persistence and great skill in preparing a viable manuscript from something
far less.
T
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CHAPTER
1
An Introduction to the
Franchise Value Approach
ORIGINS
Our work on the franchise value (FV) approach to price/earnings ratios and
equity valuation sprang from work that my associate Stanley Kogelman
and I undertook in the late 1980s at Salomon Brothers. We had been asked
to develop a valuation model to advance our understanding of a foreign equity market (one that should perhaps best remain unnamed). One of the
key questions was how much an investor should be willing to pay for the
market’s exceptional rate of growth. Since it was well known that not all
forms of earnings growth contribute to a firm’s value, Stan and I tried to
probe more deeply into the value-additive component of growth, which we
chose to characterize by the term “franchise value” (FV).
At the outset, we decided to base our analyses on the price/earnings
(P/E) ratio. Among market practitioners, the P/E ratio is a key valuation
measure, even though it has received inadequate and often dismissive treatment in the academic literature. In attempting to connect the P/E ratio to
the FV component of growth, we stumbled upon a reformulation of the
standard Dividend Discount Model (DDM) that had a number of very desirable characteristics—simplicity, intuitiveness, and in many ways, broader
generality. This FV framework also proved to be extremely provocative,
opening the door to a series of analytical papers that explored different
facets of the problem of corporate valuation. This volume is a compilation
of those papers.
WARNING: THE LIMITATIONS OF ANY MODEL
Before we describe the franchise value approach and its implications, we
should first provide some general background and “warning labels”—
1
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FRANCHISE VALUE
caveats that apply quite generally to conclusions drawn from any financial model.
By its very nature, a model is an abstraction of a more complex reality.
Consequently, any real-life investment decision should always incorporate
a more comprehensive set of judgments and considerations than can be
provided by any given model. The studies in this volume are intended only
to illuminate certain facets of the valuation problem, and hence these findings should not be interpreted, by themselves, as the basis for any investment decision or action.
This warning about the potential abuse of modeled studies applies
with special focus to stocks because of their extremely complex nature. In
addition, many of the variables incorporated into the following studies
represent convenient hypothetical constructs. For example, in the following discussions, the term “current earnings” refers not to the accounting
earnings in any one period, but rather to the hypothetical annuity comprised of the net cash flow that could be distributed in perpetuity from the
current book of business. Similarly, the return on a new investment is also
represented as a PV-equivalent annuity consisting of the distributable cash
flow per dollar invested.
By its very nature, our FV approach has certain built-in biases that
should be well-recognized in advance. In equities, much of what can be
modeled acts to delimit a firm’s value. Models capture those prospects that
are visible and can be foreseen. However, to the extent that productive
growth and future profits are visible, they should theoretically already be
incorporated into the stock price. Hence, one should not be surprised when
model-based forecasts show limited further growth in the company’s value
(even when there may be considerable growth in the firm’s earnings). Indeed, with all visible future earnings embedded in the model estimate, we
should expect to more typically see the firm’s value and P/E ratio decline as
the prospective earnings are consumed.
To be sure, one hears of superoptimistic projections being touted on
the basis of some model or another. However, under close examination, as
one peels back the underlying assumptions embedded in these models, one
typically finds that continuous profitable growth is taken as a given, without any grounding in the more fundamental sources of return and the ultimate equilibrium that competitive forces should drive them toward.
Indeed, some of the claims for astronomical P/E ratios are addressed—and
questioned—by a number of the chapters in this volume.
It may be in the nature of human organizations and systems that
problems and limitations loom visibly in front of us, whereas our ways of
dealing with them—and their unforeseen opportunities—are lost in the
fog of future possibilities and lie beyond the clear horizon of our foresight. Good models deal with that which can be reasonably foreseen and
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3
estimated, an inherently limiting condition when the really positive news
arrives unannounced. This may be another reason why economics is
called the “dismal science.”
The good news here is that every experienced equity analyst knows
that models—no matter how sound—can carry you only so far. At some
point, one has to rely on a form of faith that an attractive company has the
right stuff that will enable it to grow beyond the visible franchise (that
should be already in its pricing) and to develop and capitalize on opportunities that are as yet unforeseen.
We have referred to this positive faith as a hyperfranchise, and believe
that it is some combination of the presence, resources, confidence, and dynamism that enables a firm not only to be great, but to stay great in the
face of a rapidly changing world.
If everything foreseeable by the market is already embedded in the
price, how can any security ever provide the analyst’s holy grail—a return
that exceeds the risk-adjusted discount rate? Putting aside any discrepancy
between what the analyst believes to be his or her better foresight, the answer must depend on rather amorphous considerations such as:
1. The successful realization of projects with initially uncertain outcomes.
(Essentially, this effect can be viewed as a shrinkage in the risk premiums for some facets of the firm’s business.)
2. The emergence of positive surprising new opportunities (or unforeseeable problems) that could not be formally incorporated into any
model.
For a given firm, these factors are not likely to be just random occurrences. Firms that have a positive hyperfranchise will have the innate ability to bring productive projects to fruition, to make good things happen,
and to uncover and effectively exploit new opportunities. In the final
analysis, the ability to assess a firm’s hyperfranchise potential may be the
most critical talent that an analyst can possess. Unfortunately, or perhaps
fortunately, the uncovering of such hyperfranchises falls outside any good
modeling, and into the realm of art—and faith.
Thus, analysts find themselves trying to deal with visible islands of
probable franchises and (antifranchises) surrounded by a murky sea of
only possible hyperfranchises (and anti-hyperfranchises—surely there are
bad surprises as well!). Given this situation, what is the role for the
model—even the best model? Simply put, by incorporating all the factors
that can be estimated in the best possible way, the analyst comes to know
the knowable. In an efficient, competitive market, the pricing of any security is the net result of the analyses and needs of many participants, with
at least a goodly number of them being pretty well informed (especially