Looking at cost, not value

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Regardless of what something seems to be worth, I should never pay more for something than it would cost me to replace it. On this basis, mobile phone companies look expensive.

The Forth Bridge is a marvel of Victorian engineering. But today only a few trains a day amble across it from Edinburgh to Kirkcaldy. If it did not exist, no-one would now think of building it. Its value is far below its replacement cost.

Like most people, I cannot imagine life without a car. Its value to me is so large that it is hard to quantify. But when my insurance company asks me what it is worth, the answer I give is the cost of buying another car like the one I have.

The Central Electricity Generating Board, before it was privatised, put the value of its fixed assets at almost £30 billion. That figure measured what it would have cost to rebuild the generating capacity it had expensively and expansively created. The flotation value of the two main successor companies, National Power and Power Gen, was around £4 bn. That valuation measured what the CEGB stations were likely to be able to earn in a competitive electricity market whose prices were governed by the cost of building new combined cycle gas turbine plant.

There is a key principle which unites these three examples. It is that the economic value of an asset is the lower of the net present value of its earnings (the earnings basis) and the replacement cost (the replacement basis).

The theory behind this is simple. A situation in which the earnings basis exceeds the replacement basis will not normally persist. Replacement cost defines what it costs someone else to enter the market. If the amount they can earn exceeds that figure, then they will. On the other hand, if earnings are below replacement cost, others will find it too costly to imitate what you do. As your asset depreciates, it will not be replaced. Until then, you can expect to enjoy the cash flows the asset generates.

There is ample evidence to support the theory. There are ready markets for some assets, such as ships and aircraft. Sometimes there is a glut and prices fall below replacement cost. Then new ships are built, orders are cancelled, and prices remain low until the surplus is scrapped. But prices rarely rise above replacement cost for long. That stimulates new construction until value again reflects the costs.

These principles apply to firms as they do to assets. For the majority of successful, established companies the replacement cost of building such a firm is unimaginably high. You cannot imagine replicating Barclays Bank, because you would have to reproduce two hundred years of history. Instead, you use an earnings basis, while applying the test which the CEGB failed: what would it cost to provide these services in the most modern, efficient way?

At first sight, the cost of reproducing Coca-Cola seems far below its current value. Its tangible assets are only a small fraction of its market capitalisation. But not really: given the market position Coke enjoys, you could probably not replicate it however much you spent. After all, Pepsi have tried for decades with only partial success.

We find a different situation when we turn to Lastminute.com. the aptly named internet stock whose impending flotation by Morgan Stanley was announced recently. Lastminute.com was founded last April by two young entrepreneurs. Lastminute.com provides a website which allows buyers and sellers of last minute services, such as vacant seats on package holidays, to be brought together. But if we ask what is the replacement cost of this admirable facility, the answer is a good deal lower than the £400 million valuation which has allegedly been attributed to it.

The same analysis can be applied to more substantive businesses. Take One2One, the smallest of the four British mobile telephone companies. Deutsche Telekom has just paid £8.4 billion for it, against an initially canvassed valuation of £11 billion. Yet you can build the infrastructure to provide national mobile phone coverage across Britain for around a billion pounds. One2One has more than 2½ million subscribers. This is an impressive number. But we know from the mobile phone market and other utilities what it costs to establish a sales network and offer incentives to persuade people to sign up to an essentially identical service at a slightly lower price. The answer works out at between £100-£200 per customer you capture. That puts the replacement cost of One2One’s customer base somewhere in the range £250m – £500m.

On the most extravagant assumptions, it is hard to put the cost of replicating One2One at more than a quarter of the price Deutsche Telekom paid. The reality check of replacement cost introduces competitive dynamics into earnings projections. If earnings are so far above replacement cost, entry and rivalry will force these earnings down. (As a matter of fact, One2One has yet to make a profit.) True, there are only four British mobile networks, but there will be more, and the expansion from two to four has already brought lower prices. Internet advertising and mobile telephony are both wonderful businesses, but that alone ensures that their future will be fiercely competitive.

The current emphasis on earnings projections and neglect of replacement cost is sometimes justified by a belief that replacement cost is irrelevant: the first entrant to a market enjoys all the benefits of its subsequent growth. Our experience of business history is entirely otherwise. If this theory were true, General Motors and Toyota would not be leaders among many automobile companies,: Tesco and Sainsbury would not be leaders among many British food retailers, and Philip Morris would not be leader among several tobacco companies.

Almost all markets quickly become competitive: market leadership goes to those who enjoy competitive advantages: and high profits are the result, not of market expansion as such, but of strong and sustainable competitive advantages. Whatever else happens in the New Economy, the basic laws of market economics remain unchanged.

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