Whilst a franchise in a typical sense is where a business model and brand is identically replicated by an authorized franchisee, an economic franchise is quite different.
As per Warren Buffet’s letter to his shareholders in 1991, he claimed that an economic franchise is as follows: “An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.
In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management”
In more simplified terms, an economic franchise is akin to the golden egg in a basket, with the ability to withstand economic pressures, constantly changing market conditions and of course, the threat of competition. The key to identifying a legitimate franchise is not just a company that ticks the boxes of high margins and profitability (although this is extremely important), but also whether it can sustain this growth and remain a stable investment. As we will see in more detail below, the criteria to find a genuine franchise consists of a high return on assets, large barriers to entry or “moats” so competition is limited, a strong history of returns, a strong and disciplined management team along with arguably one of the most important factors; low levels of leveraging and debt.
Discounted Cash Flow (DCF) Analysis
The value of a stock can be calculated by analyzing future cash flows the company is expected to gain, then applying a discount to give a current or real time valuation whilst allowing for the risk factor of the business and the time value of money.
According to Warren Buffet, a stock’s market value is dependent on the return on invested capital in excess of its cost of capital. In other words, the value of a business rises in proportion to how high the return on invested capital is over the cost of its capital.
It is imperative that a business experiences a high return on capital due to the fact re-investment in the business will always be necessary in order to sustain and increase its growth and capacity. Unless a business is able to ensure its return on capital invested is higher than the rate of return the broader market offers, re-investing in the business will have the effect of reducing the overall value. This is due to the fact that any investment back into the company which receives less than the market rate equates to a negative return.
Finding a Successful Economic Franchise
It is essential that a stock which falls into the economic franchise category has the benefit of one or even several competitive advantages or “moats”. This competitive advantage could be in the form of being a natural monopoly, being a unique brand, have a high intellectual property value or even just be in a specialist industry.
There are several formulae and calculations that can help identify whether a stock is an economic franchise:
Return on Assets (ROA)
ROA = Net Income before Extraordinary Items/Total Assets
Return on Equity (ROE)
ROE = Net Income/Book Value of Equity
Return on Capital (ROC)
ROC = EBIT(1 – Tax Rate) / (Book Value of Debt + Book Value of Equity – Cash)
The Return on Capital (ROC) uses Earnings Before Interest and Taxes (EBIT) as opposed to net income in the formula.
Gross Profits on Total Assets (GPA)
GPA = (Revenue – Cost of Goods Sold)/Total Assets
The most important consideration when applying any of the above formulae and calculations is the relevant formula’s ability to estimate excessive returns for the future. The focus here is in the actual performance of the company or business itself, as opposed to how the share price is faring and performing.
Longevity of Excess Returns
The concept of franchise investment is more complicated than initially meets the eye. The sustainability factor of excess returns in the long run can be an issue for many companies. This is a similar concept of a business initially benefiting from economies of scale but soon this “honeymoon period” wears off and this can quickly turn from the benefit of economics of scale into the burden of diseconomies of scale.
Economies of scale are where a company can benefit from cost advantages due to production efficiency increasing and thus the cost per unit can reduce dramatically. When diseconomies of scale kick in, the initially slick business operation develops issues resulting in a larger company, but an increase in cost per unit due to inefficiency in various areas from management to production.
Whilst diseconomies of scale are not necessarily a direct reason for excess returns beginning to dwindle over time, when sampling several stocks with a high return, majority of these will be at their prime from a business operations point of view so will not be representative of its performance over an average period of time or business life cycle.
Another reason is that competition can play a big part in a company’s excess returns. This is due to the fact that other companies will try to emulate the business model of a successful company generating excessive returns. As a result the unique company that had the competitive advantage has to lower its costs to keep up with the competition, effectively eating away at the high returns over time, as these high returns can very quickly become average returns.
By analyzing stocks which already have the characteristics of a franchise (i.e. a high return on capital invested), it is likely these stocks will be able to be stronger picks and result in a higher chance of them earning excess returns in the long run.
In order to find these strong long term picks and therefore be a serious contender for a stock watchlist, we need to look at various statistics and calculations that show how well a company is performing and check this against the broader market. This analysis period should be over a long enough business cycle, with 8 years being a time frame which should give a good indication, having allowed a company to go through the various peaks and troughs of the economy and markets.
These variables are as follows:
Long Term Free Cash Flow on Assets (CFOA)
CFOA = Sum (8 Years Free Cash Flow) / Total Assets
Free cash flow is calculated by adding the net income to the depreciation and amortization figure – the change in working capital and capital expenditure.
CFOA is used to measure the amount of cash that has been created over an eight year period, above and beyond any capital expenditure.
Long Term Geometric Return on Assets (8yr_ROA)
This is the result of the geometric average of the return on assets (ROA)
Long Term Geometric Return on Capital (8yr_ROC)
The result of this is the geometric average of the return on capital (ROC)
As a general rule, in order to qualify for the franchise status, a company would be expected to have high outcomes on the last two metrics at least. Also, a stock would have to display a high level of robustness over this eight year period to be considered a strong enough pick for a franchise. In other words, showing excess returns and high performance over a short period of time simply just does not give a strong enough indication that a stock is a definite franchise, hence the eight year period being crucial.
Margins and Pricing Power
The ability to increase prices without the fear of customers going to a business’s competition, along with consistent, high profit margins are also indicative of a strong economic franchise. Of course, for any business if costs can be mitigated and controlled first and foremost, this allows high margins to be protected without the need to increase prices.
The strength of a company’s profit margin can be measured with two main calculations. The first is margin growth (MG), and the second is profit margin stability (MS).
Margin Growth (MG)
Margin Growth is a measure of a stock’s profit margin in the long run from a geometric growth standpoint. A stock is considered to be more attractive the higher the margin growth level.
MG = Geometric 8 year average
In simple terms, if we take the seven year compound annual growth rate as a profit margin, we are left with the MG value.
If there is a good level of sustainable margin growth this would indicate again that a stock is a potential franchise.
Margin Stability (MS)
Margin Stability is a measure of how effective a stock is at keeping its profit margin levels during a typical business cycle.
MS = Geometric 8 year average of gross margin/standard deviation of gross margin
Maximum Margin (MM)
Whilst both helpful indicators, each one analyzes a different part of the performance of profit margin, therefore, there is a lack of consistency. For example, margin growth focuses on the actual growth of margin, and margin stability focuses on how likely a stock is to sustain this profit margin over a period of time and therefore how reliable it is from this viewpoint. It can be difficult to decide whether a stock is a franchise if there is a great result from, say, a growth margin viewpoint but a poor margin stability value. This is where the maximum margin indicator (MM) can be a helpful way of finding a franchise as it blends both the growth and stability elements together.
MM = Max (Percentile (MS), Percentile (MG))
This maximum margin value takes each stock’s best performing profit margin metric and awards this rank to the stock. In simplistic terms, it goes into more detail allowing a stock to show its main strength, whether this be its strong growth or high margins without devaluing the stock if, for example, it has strong growth but low margins or high margins but slow growth. The reasoning behind this MM calculation is so that it takes everything into account and an overall picture (or a less “black and white”) one can be seen. By using percentile ranks for the profit margin growth and profit margin stability factors, the maximum margin can easily be compared across a range of stocks.
Identifying Economic Franchises & Real World Use of Formulae
Above, we mentioned how assessing a company’s return on assets (ROA) would give an indication of its franchise status, with a high ROA value being needed to qualify.
A perfect example of this would be Mastercard. As of 2019 its ROA was approximately 27.8% and in addition to this, its return on equity (ROE) was approximately 130% during the same year. When compared to an average return on equity average of 8.76% in the financial transaction services industry this is quite incredible. The above examples of Mastercard’s ROA and ROE show how it could very well qualify for franchise status, as these statistics also align with the idea that an economic franchise would need to have a strong brand along with be market leader.
By employing the measure above it is also evident that we can filter stocks in the market to the top 10 percentile as economic franchises are certainly not a dime a dozen. Therefore, those that qualify will in a sense already be top picks, which will naturally mean that a watchlist of stocks will be even further solidified by taking into account the factors we have discussed.
We have seen how a stock which has this franchise quality about it is able to price itself high which creates a natural domino effect with the company benefitting from higher margins and a subsequent higher return on capital employed.
There are several “green flags” for a stock that is a potential economic franchise, and that is evidence of high profit margins which are stable, along with a high return on capital which is also consistent.
It is also important to consider that whilst many businesses can show signs of possessing a franchise stock, a short term range does not give an accurate indication, therefore a longer period which accurately reflects a long enough period or business cycle (in most cases eight years). Using measures such as the CFOA, ROA and ROC, we are able to identify this more accurately.
From a profit margins perspective, it is assumed that a franchise firm would also show signs of consistent high margins and good overall company growth. Using the maximum margin and margin stability indicators we can combine these calculations to also calculate the maximum margin and help us to find a legitimate and high quality stock franchise.