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EVA appears to be a very important, only?, criteria for investing our money in a company. I would like to understand EVA better and I hope this post helps to generate further discussion and understanding of this concept.

EVA is the measure of a company's ability to generate value above that which an investor can expect to receive from less risky investments, e.g., 30 year Treasury bonds, S&P 500 index. A company's EVA can be shown on a Competitive Advantage Gap (GAP) and Competitive Advantage Period (CAP) chart, with GAP (returns) on the Y-axis and CAP (time) on the X-axis.

The GAP/CAP chart displays the projected company's market capitalization over time with future values discounted to their present values. From page 100 in the revised GG book, the theme of this chart is earning the right to an investor's capital.

The market tends to reward companies that have consistently strong up-side revenues/sales (returns) and no perceived viable competition (time) with increasingly larger market caps and high Price/Sales (Market Cap/Total Sales for last 12 months) ratios.

For me, GAP is easier to understand and monitor. For example; the continuing 100%+ sales increases year-to-year by JDSU of its products and its improving Gross Margins are reported every quarter and it is easy to see why the market normally rewards the company - and its investors - with increasing market caps. OK, OK, There are those notable exceptions when the market becomes even more manic-depressive than normal, like now.

On the other hand; CAP is easy to understand but confusing and difficult to monitor. Understanding, at least conceptually, is easy - Is there a viable existing competitor or one looming on the horizon? What makes if difficult to monitor is all the dis-information available. Digressing for a moment - If you ask Larry Ellison, there is a viable competitor for almost anything (Internet, CRM, B2B, etc.) - Oracle.

This may be one of the reasons the market feels more comfortable expanding a company's GAP than expanding its CAP.

None of the above has yet differentiated between the high tech GG companies and any other companies thus far.

Harold
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For me, GAP is easier to understand and monitor.

On the other hand; CAP is easy to understand but confusing and difficult to monitor. Understanding, at least conceptually, is easy - Is there a viable existing competitor or one looming on the horizon?

I agree. GAP is far more tangible than CAP. We can see the market share growing, the acceptance of a particular company's architecture as the standard, the alliances, the contracts being signed--the wave is hitting us or at least beginning to fill our field of vision. We also know other waves are forming out there, but when will the next big one come? Discontinuous innovations, which are the inevitable demise of all gorillas, are nearly impossible to predict--that is with any degree of confidence as to exactly when, who, and how they might manifest themselves. There are simply too many variables. It's my impression that major innovations often depend on the development of many other smaller tech advances, which by themselves often go unnoticed, but accumulate towards some critical convergence in the mind(s) of very clever people. This process is clearly accelerating as ideas seem to be proliferating (It is interesting to think about why this is the case). Looking five years forward is a long time in technology, so CAP is even less predictable in these markets than in "old economy" markets. But even "back then," perhaps people were not very good with CAP estimations--the Gardners' recent book notes that 10 shares of Coke bought when the company went public in 1919 would now be worth $75 million!--some CAP, eh?
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Robert: I apologize for not getting back sooner. I have been helping to set up a group for further analysis of Rule Breakers - a follow on to the recent RB seminar.

You said: GAP is far more tangible than CAP. ... There are simply too many variables. ... This process is clearly accelerating as ideas seem to be proliferating (It is interesting to think about why this is the case).

First, TMF Fuz (John) has added some quantitative help with GAP with his article on The Threshold Margin at www.fool.com/research/foolsden/foolsden.htm

I'm not sure how or if this article helps with CAP, other than allowing a direct comparison of Threshold Margins between competitors.

The accelerating prolieration of ideas you note may be the result of a combination of 1) 95%+ of the scientists and engineers who ever lived are alive and producing today and 2) multitude of examples where the pursuit your ideas can be financially rewarding.

You continued: that 10 shares of Coke bought when the company went public in 1919 would now be worth $75 million!--some CAP, eh?

I suggest that Coke had viable competitors for most of those 81 years between 1919 and now. I think the growth to 75M reflects more "those joint engines of growth" that Tom Gardner referred to in his Oct 99 RM seminar - Time and Positive Returns, e.g, Compounding - than it does CAP.

Note: While the Market has dipped, swayed, and maybe built a base for future increases; many of the companies we talk about here at the GG board have continued to pursue 50 to 100% year over year Sales increases with improving margins. What else can they do, only add EVA to the economy. They do this thru wages to their employees, materials purchased, and building shareholder value.

Harold
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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.

Best,

John Del Vecchio
Investment Research Fool
The Motley Fool
http://www.fool.com
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TMFFuz (John) wrote: 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.

John: First, if I find a company with a much better threshold margin than any of it's competitors, that would probably influence my expectations of its CAP. Secondly, the following seems to show a divergent view from the market.

The past few months have been a horrible time to have money invested in the stock market, Right? QQQ has only recently come back to 0% gain YTD. The only good thing one can say about 0% YTD is that it is better then the -7% YTD of the NASDAQ Composite, the -8% YTD of the DJIA and the -2% YTD of the S&P 500 indices. But wait; these hairy simian and large girth noble companies are supposed to lose less market value in a down market and rebound quicker then the rest of the lot, because they have more EVA - Right? Isn't that what we tell ourselves and Newbies to this board?

In fact; while the NASDAQ languishes some 30% below its high set back in March and 7% below its early Jan close, one company's stock is only two points below an all-time high and six of the nine evaluated companies have gains in excess of 40% YTD.

For this study, I selected nine companies which I compared YTD gains and 1 Mar-TD High/Lows, and list Today's (6/13) price/share. I used the 1Mar-TD time frame of the YTD % chart, since the indices turned negative about that time and stopped helping support higher stock prices.

Company YTD 1 Mar-TD Today's
Symbol gain High / Low Price
JNPR 100% 175% 30% 237+
NTAP 100% 190% 0% 86+
SEBL 75% 100% -12% 150+
INTC 53% 72% 30% 131+
ORCL 47% 60% 7% 81+
JDSU 42% 85% -7% 121+
EMC 28% 31% -3% 71
CSCO 20% 52% -7% 65
GE 2% 7% -19% 51+
QQQ 0% 29% -20% 94+
NASDAQ -7% 23% -22%
DJIA -8% 2% -14%
S&P500 -2% 3% -8%

Using this data, lets examine the above two assertions.

1) While the three indices were losing 45%, 16% and 11%, respectively, from their highs; all nine companies lost a higher percentage of their market caps than their respective indices. Assertion #1 seems to have failed. However, this was because the companies had higher highs than their respective indices since only one of the nine companies matched the low of these indices - GE. GE is a good non-GG company I added for comparison. Did assertion #1 fail?

2) While the three indices have gained 15%, 6% and 6%, respectively, from their lows and are still losing to their early Jan 00 close ; all nine companies have regained a higher percentage of their market caps than their respective indices and all of the nine companies are above their early Jan 00 close. Assertion #2 seems to have held.

As an example of the EVA capability of the first eight GG companies in the above list, please see Phil Weiss' May 10, 200 article on Cisco, linked below:

http://www.fool.com/portfolios/rulemaker/2000/rulemaker000510.htm

This article highlights a year-over-year revenue growth of 55%, year-over-year cash balance growth of 129%, and, sequentially, optical business sales growth above 60%.

Harold

PS: Please suffer my percentages. They are my engineering extrapolations taken from Big Chart % graphs on the TMF Portfolio section. Any minor errors in these percentages shouldn't negate the results of this study.


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