Market-Implied Competitive Advantage Period (MICAP)

Competitive advantage period (CAP), also known as Value Growth Duration, is the time during which a company is expected to generate returns on incremental investment that exceed its cost of capital. This term, first used by Michael Mahboussin at Credit Suisse First Boston in 1997. Economic theory suggests that over time it will attract competitors that will accept lower returns and eventually driving industry returns lower to the cost of capital. So, the company enjoys the higher valuation until the period of competitive-advantage.

The concept of CAP was first expressed by by Miller & Modigliani in 1961. The M&M equation can be summarized as follows:

Value = NOPAT / WACC + I (R - WACC) * CAP / (WACC * (1 + WACC)) 

This gives,

CAP = (Value * WACC - NOPAT) (1 + WACC) / I (R - WACC) 

where,
CAP = competitive advantage period
NOPAT = net operating profit after tax
WACC = weighted average cost of capital
I = annualized new investment in working and fixed capital
R = rate of return on invested capital

Market-Implied CAP (MICAP) is one of way of estimating CAP. It is believed that unbiased market expectation (in terms of current share price) captures the CAP. To determine MICAP, current market price (CMP) of share is used as a key input into a discounted cash flow (DCF) valuation model. Since, by definition, there is no value creation assumed after CAP, the model uses a perpetuity assumption (NOPATCAP/WACC) for the terminal value. Next, the length of the forecast horizon is stretched as many years as necessary to achieve the current stock price. This period is the company’s MICAP.

As one can notice, the MICAP determination process is a circular exercise. Example:
1. Let us say CMP or fair value of company's share is 200 INR per share

2. Take duration for forecast as one year. Perform DCF and compute value per share. i.e.

FCF-1 + TV1 = EV

EV - Debt = Equity Value

Value per share = Equity Value / Number of Shares

Say, above FCF-1 based calculation gives 120 INR per share.

3. Since, CMP (=200) > 120 so then recompute the value by taking two years as duration 

FCF1 + FCF2 + TV2 -> Value per share

4. Keep on doing this exercise until CMP remains greater than free cash flow based valuation, and stop when CMP < free cash flow based valuation. This way one can find out intuitive appeals about number of year that market believes the company will enjoy the competitive advantage.

Usage of MICAP

• The value of any asset can be expressed with a limited number of variables— in particular, cash flow, risk and MICAP.
• If a stock price increases without changes in cash flow expectations and/or risk, the MICAP will necessarily expand.
• If the CAP for a value-creating company remains constant, an investor can expect to generate excess returns over time.
• Growth without excess returns will make a firm larger but not more valuable. A relatively slow-growth, high-return company in a stable industry may well command a higher valuation (i.e., higher P/E, price/book value, etc.) than a fast-growing, high-return company in rapidly changing industry.
• Company with high MICAP are good for long-term stock-holding.
• Higher CMP does not implies high MICAP.. E.g. where entry barrier is low, MICAP is low.. e.g. IT industry.
• If MICAP (say 8% over 4 years) of a company does not seems realistic, analyst should then validate the assumption related to sales growth and operating profit margin.

 Original Research Paper by Michael Mahboussin can be found at following link: www.capatcolumbia.com/Articles/FoFinance/Fof1.pdf‎