Wednesday, April 22, 2015

Valuation of the ability to command prices: The brand

“Your premium brand had better be delivering something special, or it's not going to get the business.”
Warren Buffett

Willingness to pay for a brand is something that has to be measured in the marketplace. If you are looking at something like Tide from P&G and see a generic washing powder you could see the reaction of people who may or may not pay up for the brand. Another way to check this is to compare the margins of the company in question with competition and with generic manufacturers of the same thing. Ajanta pharma is a generic branded formulations manufacturer whose margins are more than the non-branded generic manufacturers.

The value of the brand is not a separate activity but included in the financials. If you look at businesses such as Colgate or Hindustan Lever, they have such strong brands that their return on invested capital (ROIC) is north of 50% and some can argue that Colgate is north of 100%. Think about that. If they invest a 100 rupees into their business they get 50 to 100 back just in the first year. And that continues to happen year after year. They of course cannot continue to invest a significant portion of their earnings into the business because there isn't that much market for their products so a majority of what they earn gets paid out as dividends. For a 100% ROIC business, a 20% growth rate, would mean they pay out 80% of their earnings every year as dividends. This dividend cash flow and the growth, using the same Fair P/E formula is how this brand should be valued.

On the flip side luxury brands aren't always economically excellent. From a value investing perspective a Hero Honda or Bajaj Auto is a far superior brand than Daimler AG. The return on capital for the former 2 companies is north of 40% whereas Daimler AG has an under 10% return on capital. This is very difficult for automotive enthusiasts to swallow but it’s true.

Another concept that I find hard to explain but is also relevant is that margins are important but not as important as return on invested capital. If a brand has 50% margins but 10% returns on capital that just means they are overpriced to the point where the capital turns just don’t justify the existence of the brand.

So to summarize the valuation of the brand – it is only as good as the return on capital it generates. There is not special formula to value it, just the same simple old fair P/E formula of growth, return on invested capital and discount rate.

This article is a continuation of the following:

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