Read: Keeping the Horse Before the Cart: Valuentum’s Economic Castle™ Rating
The Economic Castle Focuses on the Magnitude of Economic Value Creation
The Valuentum Economic Castle™ rating is an enhancement of the competitive advantage framework (commonly known as economic moat analysis) that has become widespread and ubiquitous within the investing world. Whereas an economic moat framework evaluates a firm on the basis of the sustainability and durability of its competitive advantages, Valuentum’s Economic Castle™ rating evaluates a firm on the basis of the firm’s future economic profit spread (return on invested capital less its weighted average cost of capital).
The companies with the strongest Valuentum Economic Castle™ ratings are poised to generate the most economic value for shareholders in the future, regardless of their competitive positions, the nature and specificity of the trajectory of their future economic value streams, or their price-to-fair value ratios. The image below walks through the foundation behind the Economic Castle™ rating, a breakthrough in assessing a company’s business quality and its ability to deliver economic value to shareholders.
Image Source: Valuentum
The core problem with economic moat analysis is that the sustainability and duration of a firm’s economic value creation – or its competitive advantage period – tells us little about the amount of value a company is expected to deliver to shareholders, or a company’s economic castle. Though a focus on economic moats is important to Warren Buffett’s process, identifying economic castles, or those that will deliver the most value to shareholders may be equally, if not more, important to an investor’s process. Valuentum’s Economic Castle rating evaluates a firm on the magnitude of economic profit that it will deliver to shareholders. Firms with the strongest Economic Castle™ ratings are poised to generate the most economic value for shareholders, regardless of their competitive positions.
Valuentum’s Economic Castle™ Rating is Based on Two Considerations
1) the framework behind Valuentum’s proprietary ValueCreation™ rating:
ValueCreation indicates the firm’s historical track record in creating economic value for shareholders, taking the average difference between ROIC (without goodwill) and the firm’s estimated WACC during the past three years. The firm’s performance is measured along the scale of EXCELLENT, GOOD, POOR, and VERY POOR. Those firms with EXCELLENT ratings have a demonstrated track record of creating economic value, while those that register a VERY POOR mark have been destroying economic value. The ValueCreation rating can be found on the second page of each company’s 16-page report.
2) a forward-looking assessment of a firm’s expected economic returns over the immediate five-year period.
Our view is that the most economic value for the largest value-contributors will be generated over the immediate forward five-year period. These returns are not weighed down by the compounding dynamics of a discount rate and are not nearly as exposed to the forecasting error that occurs in later stages within any modeling framework. A firm that is generating an economic profit spread of 100 or so percentage points may generate more value for shareholders over a shorter time period than one that generates 1 or 2 percentage points each year for decades into the future. The average 5-year forward ROIC-less-WACC spread can be found on the second page of each company’s 16-page report, as shown later in this article.
Highly-rated Economic Castles™ can be underpriced, fairly-priced, or overpriced. Though the economic value framework and the discounted cash-flow framework are interdependent and correlated, the Valuentum Economic Castle™ rating is independent of a firm’s price-to-fair value assessment. The rating only considers the economic value that a firm generates for shareholders, in the same light that the concept of an economic moat considers only the sustainability and durability of a firm’s competitive advantages.
The Categories of Economic Castle™ Ratings
Though the ValueCreation™ rating, which considers the value-generating capacity of a firm during the past few years, is used by our analyst team to make qualitative adjustments, the average 5-year forward ROIC-less-WACC spread is the primary yardstick used to assign Economic Castle™ ratings to companies in our coverage universe:
HIGHEST RATED
Average 5-year Forward ROIC-less-WACC spread > 150%
VERY ATTRACTIVE
Average 5-year Forward ROIC-less-WACC spread between 50% and 149.9%
ATTRACTIVE
Average 5-year Forward ROIC-less-WACC spread between 3.1% and 49.9%
UNATTRACTIVE
Average 5-year Forward ROIC-less-WACC spread less than 0%-3%.
Note: Firms with marginal 5-year average economic profit spreads of 0%-3% can either be assigned ‘Attractive’ or ‘Unattractive’ Economic Castle™ ratings on the basis of their ValueCreation™ rating and the judgment of the Valuentum analyst team.
Members of Valuentum should expect the Economic Castle™ rating to replace the ‘Last Close’ data that is currently found on the top of each page of the 16-page reports. For real-time pricing data and volume information, we encourage members to use the TradingView charts that can be found on each firm’s landing page. The average 5-year forward ROIC-less-WACC percentage can be found on page 2 of each firm’s 16-page report. Both of these items—the location of the Economic Castle™ rating and the location of the average 5-year forward ROIC-less-WACC percentage—are highlighted in the page-2 example below.
Image Source: Valuentum
The following will be the initial industries to reflect the Economic Castle™ rating in their constituents’ 16-page reports – their expected publish dates are listed below. In the spirit of transparency, the 5-year forward ROIC-less-WACC spread is already currently included in each firm’s report. All companies in Valuentum’s coverage universe will eventually include an Economic Castle™ rating in their reports as outlined in this article.
June 22: Environmental Services: CLH, CWST, DAR, ECOL, RSG, SRCL, WCN, WM
June 23: Semiconductor Equipment: AMAT, ATMI, CREE, KLAC, LRCX, MKSI, SNPS, TER, UMC
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