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Subject:  Re: Economic Value Added (EVA) Date:  6/12/2000  1:13 PM
Author:  TMFFuz Number:  2866 of 8806

Hi Harold,

The threshold margin may indeed help with GAP (I never thought of that), but it certainly does not help with CAP, in my opinion. CAP is fundamentally based on expectations in the marketplace. You only benefit when you have a divergent view from the market. The theory here is that the market (meaning the analysts) are underestimating the potential of the leaders in a particular space. Hence, their expectation has diverged from reality. So, the market may be saying that XYZ has a 10 year CAP, but your knowledge of how technology markets form (via the GG) provide a framework for analyzing product adoption, barriers to entry, increasing returns, and switching costs that may not fully be factored into the equation. So, the actual CAP may be 15 years, in which case you will earn superior returns by investing in XYZ.

I also agree with you about Coke.

Coke never had an 81 year CAP. That is not why an investment in 1919 is worth $75 million. If the CAP expands you will earn excess returns. If the CAP stays the same, you can still earn the required rate of return. So, we could assume that for 60 years, Coke had a CAP of say 10 years and never moved. Then, you may have earned 12% on your money. Then, in the early 1980's, with the introduction of Diet Coke, and the internal implementation of EVA as a management tool for Coke, the CAP expanded to 20 years, and the returns were huge. Then, in recent years, the CAP likely shrank due to concerns about products in foreign lands.

The numbers above were purely made up by me, but it shows how a company does not need a forever expanding CAP in order to create a huge return 81 years later. Time and compounding are very well the likely reason why this happened. Not CAP.

Another example is Microsoft. Mike Mauboussin at CSFB has stated that MSFT had a CAP of 3 years when it went public. That expanded to 8 years at the release of Windows 3.1. Then it expanded to 25 years in the late 1990's. Well, now it had suffered some serious shrinkage due to the trial.


John Del Vecchio
Investment Research Fool
The Motley Fool
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