Saturday, April 7, 2012

Competition Demystified: Chapter 16

The author of the excellent book for beginners, Value Investing: From Graham to Buffett..., is back, this time with a book about how to understand and analyze competitive advantages. Investors interested in better understanding what gives a company a competitive advantage must give this book a read.

This chapter discusses the valuation of companies incorporating the strategic elements discussed thus far. While calculating the net present value of an investment is theoretically sound for determining whether an investment decision should be made, in practice this method suffers from a number of defects. First, it does not separate reliable from unreliable information. Second, it relies on a number of assumptions that can have a dramatic impact on the result. Finally, it ignores the effects of the efficient (or inefficient) allocation of resources with the generated cash flow.

The authors instead offer an alternative framework for determining whether a company merits an investment. Investors should calculate the reproduction value of assets and compare this to the earnings power value of the company to determine if a competitive advantage may exist. This approach allows the incorporation of a margin of safety, and incorporates strategic information into the valuation decision. The details of this procedure are fully discussed in the book Value Investing: From Graham to Buffett and Beyond.

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