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I'd like to begin today with a story. A story about a company that had a
meteoric rise in the late 1990s, maybe some of you are familiar with it,
Pets.com. One of those companies that caught the
.com boom. Entered the market with a novel concept of
simply selling pet supplies to customers online.
It was a company that had a simple name, an easily described business model.
Had a an icon in its sock puppet that was well recognized and loved.
And in fact had achieved great success in a very short period of time.
Having one of the more recognizable brands on the marketplace, an envy of many
companies. The sock puppet was famous for its Super
Bowl commercials, was seen in the Macy's Thanksgiving Day Parade.
A widely respected and widely visible brand.
Yet, within a couple years Pets.com was gone and out of business.
One of the first and prominent victims of the .com bubble.
What happened to Pets.com? Well, a number of things.
One, there was massive entry by others who were basically replicating the same
concept. It wasn't that hard to sell pet supplies
on line. And so, others tried as well.
The story of Pets.com is a great illustration what we like to call the
fundamental principle of business strategy.
Colloquially, if everyone can do it, it's difficult to create and capture value from
it. The fact that it was easy for others to
offer pet supplies online in essence may have doomed Pets.com to failure.
To say this more precisely and put it in more economic terms, we can say the
fundamental principle in the following way.
In a perfectly competitive market, no firm realizes economic profits or what we often
call economic rents. So, let me just take a few minutes to
define this term, economic profits. Economic profits are returns in excess of
what an investor expects to earn from investments of similar risk.
In essence what we call an excess of the opportunity cost of capital.
Think of the following scenario. You can invest a $100 million to get a $1
million return, or you can invest $500,000 and also get a $1 million profit at the
end of the day. Clearly, the latter investment is
favorable to the first investment, though they both have a return of a million
dollars in profit. The fact that you could invest your
capital in other ways is in essence the idea of an opportunity cost.
So, when we think of ec, economic profits, we're interested in those profits above
and beyond that opportunity. You see some data here on the slide
highlighting three different firms. This is all data taken from 1998, and is
represented in millions of US dollars. In the light blue, we see accounting
profits. What is often reported in the popular
press where companies have to report as public entities.
For IBM, they reported a counting profit of $6.3 billion in 1998.
However, when we factored in the opportunity cost of the capital necessary
to generate those profits, their economic profits were around 2.5 billion.
Compare that to Microsoft. Microsoft posted accounting profits less
than IBM at $4.49 billion. However, their economic profit was 3.776
billion. Now the reason for the difference here is
in part because Microsoft is not a very capital intensive business.
It's a software business and as Bill Gates has once famously quipped, it's like
printing money once you develop an operating system that becomes the standard
within the industry there. Finally, look at General Motors.
In 1998, General Motors posted a profit of around $2.9 billion.
However, if we think about the economic profit that General Motors generated, it
actually was a significant loss. And the reason for this, once again, is
that General Motors required heavy capital investment to generate that $2.9 billion
in earnings that they posted that year. So once again, as strategists, we're very
interested in the notion of economic profits above and beyond your standing
standard accounting profits. Now, how do we measure these economic
profits? Well, there's a number of ways in which we
might do so. One that's popular amongst researchers is
what's called Tobin's Q. In it's simplest form, it's what's
sometimes referred to as the market to book ratio.
The market value of the firm, what investors think the firm is valued at,
versus the book value of the assets it actually owns and possesses.
Tobin's Q is a more refined measure of market to book where you're actually
looking at the replacement value of assets.
Take a company like Facebook today, and look at its market valuation.
It's high, very high market valuation. Yet, the replacement value it posses is
relatively very, very low when you think about the number of employees and assets
that they have on the books. What's nice about Tobin's Q is direct
measure of these rents, these economic profits, above and beyond the physical
inputs that the firm possesses. However, it's often difficult to calculate
and have real in-depth knowledge about the replacement value of assets.
The gold standard for measuring economic profits are what we call discounted cash
flows. Cash flows, in it's simplest way, are
those dollars that flow to the bottom line after profits and after future investments
that the firm might make. We're interested in the stream of those
cash flows that a firm might generate moving forward into the future.
And what we do is we discount those future cash flows.
The idea of discounting is based on the idea that money today is worth more than
money in the future, so we value more the cash flow that you generate today versus
those that you generate in the future. In this way, by this counting, we in
essence capture this notion of opportunity cost.
What if I had that money today and could invest it in a different vehicle?
When we calculate then these discounted cash flows, we calculate what we call the
Net Present Value, or NPV. And generally, a positive NPV indicates
the a creation of these economic profits or rents that we're interested in.