• Cost of capital: "Funds used to finance a business" The weighted average of a firm's cost of debt and cost of equity blended together is used to judge whether a capital project.
  • Regression to the mean: How data evens out over time because if a variable is extreme the first time it will get closer to the average the next time you measure it. In technical terms, it describes how a random variable that is outside the norm eventually tends to return to the norm.
  • Cash flow return on investment (CFROI): a valuation metric compared to the cost of capital, to determine value-added potential.
  • CFROI = (Gross Cash Flow - Economic Depreciation)/ Gross Investment
  • Measuring the moat checklist:
    1. Sustainable Value Creation is measured by the magnitude of returns in excess of the cost of capital that a company does, or will, generate. Not just the return on investment but the rate at how much a company can invest above the cost of capital. Growth = value, when ROI > cost of capital then it's a good investment. The length a company can earn returns in excess cost of capital. Also, know as the fade rate, competitive advantage period (CAP), value growth duration, or T. Focus on a company's economic performance relative to the cost capital, not competitors.
      • What of the 4 stages of the competitive life cycle is the company in?
        • Innovation: Widespread entry and exit with focuses on the development and large opportunities for ROI.
        • Fading returns: High ROI attracts competition so economic returns move towards the cost of capital. Companies still get excess returns but the trajectory of those returns is lower, so the rate of entry and exit slows down.
        • Mature: In this phase the market companies have an ROI closer to the industry average.
        • Subpar: Competitive forces and technological change can drive returns below the cost of capital, requiring companies to restructure. These companies can improve returns by shedding assets, shifting their business model, reducing investment levels, or putting themselves up for sale. Alternatively, these firms can file for bankruptcy to reorganize the business or liquidate the firm’s assets.
      • Is the company currently earning a return above its cost of capital?
      • Are returns on capital increasing, decreasing, or stable? Why?
      • What is the trend in the company’s investment spending?
    2. Assess the Industry Landscape for any companies that might impact profitability. Thing's to consider why building out the industry map: 1) List the companies in terms of dominance such as size or market share 2) Consider, potential new entrants with existing players 3) Understand the financial nature that these entities conduct business and 4) Evaluate any other factors that might influence profitability. Include a profit pool analysis.
      • What percentage of the industry does each player represent?
      • What is each player’s level of profitability?
      • What have the historical trends in market share been?
      • How stable is the industry?
        • How stable is market share?
        • What do pricing trends look like?
      • What class does the industry fall into—fragmented, emerging, mature, declining, international, network, or hypercompetitive?
    3. 3 forces (Supplier Power, Buyer Power, and Distribution Threat) from the 5 forces framework by Micheal Porter "we believe that the threat of entry and rivalry are so important that they warrant deeper consideration than the others"
      • What percentage of the industry does each player represent?
      • What is each player’s level of profitability?
      • What have the historical trends in market share been?
      • How stable is the industry?
        • How stable is market share?
        • What do pricing trends look like?
      • What class does the industry fall into—fragmented, emerging, mature, declining, international, network, or hypercompetitive?
    4. Barriers to Entry, it is important to understand the history of entry and exit for the specific industry you are analyzing.
      • What are the entry and exit rates like in the industry?
      • What are the anticipated reactions of incumbents to new entrants?
      • What is the reputation of incumbents?
      • What is the level of asset specificity?
      • What is the minimum efficient production scale?
      • Is there excess capacity in the industry?
      • Is there a way to differentiate the product?
      • What is the anticipated payoff for a new entrant?
      • Do incumbents have precommitment contracts?
      • Do incumbents have licenses or patents?
      • Are there learning curve benefits in the industry?
    5. Competitive Rivalry, to understand how fiercely each company competes against one another in a variety of dimensions such as price, service, new product introductions, promotion, and advertising. A concentration ratio is a common way to measure the number and relative power of firms in an industry. The Herfindahl-Hirschman Index (HHI) is a popular method to estimate industry concentration.
      • Is there pricing coordination?
      • What is the industry concentration?
      • What is the size distribution of firms?
      • How similar are the firms in incentives, corporate philosophy, and ownership structure?
      • Is there demand variability?
      • Are there high fixed costs?
      • Is the industry growing?
    6. Disruption and Disintegration. Clayton Christensen developed a theory that distinguishes between sustaining and disrupting innovations. Sustaining innovation operates within a defined value network and a disrupting innovation approaches the same market w/ a new value network. Disrupting innovation is separated into low-end disruption and new-market disruption.
      • Is the industry vulnerable to disruptive innovation?
      • Do new innovations foster product improvements?
      • Is the innovation progressing faster than the market’s needs?
        • Have established players passed the performance threshold?
        • Is the industry organized vertically, or has there been a shift to horizontal markets?
    7. Firm Specific analysis is how a company creates shareholder value. An effective value chain analysis requires a map of the industry's value chain, comparison between the company and industry, identify the drivers of price or sources of differentiation, and identify the drivers of cost.
      • Does analysis of the value chain reveal what activities a company does differently than its its rivals?
      • Does the firm have production advantages?
        • Is there instability in the business structure?
        • Is there complexity requiring know-how or coordination capabilities?
        • How quickly are the process costs changing?
      • Does the firm have any patents, copyrights, trademarks, etc.?
      • Are there economies of scale?
        • What does the firm’s distribution scale look like?
        • Are assets and revenue clustered geographically?
        • Are there purchasing advantages with size?
        • Are there economies of scope?
        • Are there diverse research profiles?
      • Are there consumer advantages?
        • Is there habit or horizontal differentiation?
        • Do people prefer the product to competing products?
        • Are there lots of product attributes that customers weigh?
        • Can customers only assess the product through trial?
        • Is there customer lock-in? Are there high switching costs?
      • Is the network effects radial or interactive?
      • What is the source and longevity of added value?
      • Are there external sources of added value (subsidies, tariffs, quotas, and competitive or environmental regulations)?
    8. Firm Interaction, competition and/or cooperation between the the companies in that particular industry. Companies need to stay attentive of potential reactions of their competitors.
      • Does the industry include complementors?
      • Is the value of the pie growing because of companies that are not competitors? Or, are new companies taking share from a pie with fixed value?

    9. Brands a company can differentiate itself and build a more enduring brand if it truly understands the job customers want to be done and develops its products or services accordingly.

      • Do customers want to “hire” the brand for the job to be done?
      • Does the brand increase willingness to pay?
      • Do customers have an emotional connection to the brand?
      • Do customers trust the product because of the name?
      • Does the brand imply social status?
      • Can you reduce supplier operating cost with your name?
      • How much leverage do suppliers have?
      • Can companies pass supplier increases to customers?
      • Are there substitute products available?
      • Are there switching costs?
      • How much leverage do buyers have?
      • How informed are the buyers?
    10. Management Skill and Luck, evaluate a management team and their strategies they devise based on the processes they employ rather than the outcomes they achieve. It is easy to be fooled by randomness. The top companies tend to follow 2 rules: