ValuePro The Excess Return Period

The free cash flow to the firm approach provides for several distinct time periods for estimating cash flow which allow differing value-creating periods for a corporation's business strategy. In the Excess Return Period, because of a competitive advantage that the firm has, the corporation is able to earn returns on new investments that are greater than its cost of capital.  Classic examples of companies that experienced a significant period of competitive advantage are IBM in the 1950's and 1960's, Apple Computer in the 1980's, and Microsoft and Intel in the 1990's.

Success invariably attracts competitors whose aggressive practices cut into market share and revenue growth rates, and whose pricing and marketing activities drive down net operating profit margins. A reduction in NOPM drives return on new investment to levels that approach the corporation's WACC. When a company loses its competitive advantage and the return from its new investments just equals its WACC, the corporation is investing in business strategies in which the aggregate net present value is zero (or worse yet, negativeŚwitness IBM in the 1980's and Apple in the 1990's).

The length of the Excess Return Period for the corporation will depend on the particular products being produced, the industry in which the company operates, and the barriers for competitors to enter the business.  Products that have a very high barrier to entry due to patent protection, strong brand names, or unique marketing channels might have a long Excess Return Period (10 to 15 years or longer). The Excess Return Period for most companies is 5 to 7 years or shorter.  All else equal, a shorter Excess Return Period results in a lower stock value.  

What do you use as an input for the Excess Return Period?  This is your judgment call when valuing a stock. We use what we call the 1-5-7-10 RULE