Book Reviews, Valuation

Book Review: Sources of Value

Book: Sources of Value by Simon Woolley (BP)

Review: Interesting topic. This aims to break down NPV and attribute the components into identifiable advantages of a company over its competitors. Most of the time when you identify sustainable competitive advantage for a company, its terminates as a qualitative judgment. This book takes it one step further to quantify exactly how much that is worth. While it may not be necessary for deciding and making investments, it is definitely good to know. It is more relevant also for companies making their investments in various projects.

Key Points:

  1. SACP Analysis (Sector Attractiveness – Competitive Position) or GE-McKinsey Matrix.
  2. Return on Capital Employed (ROCE) = (Funds Flow + Growth in Capital Employed) / Capital Employed
  3. Funds Flow = Profit – Growth * Capital Employed
  4. ROCE of a company is a first-order approximation for the average IRR that it is earning on all of its investments. Usually ROCE overstates the average IRR, because companies are required to reduce the book value of their assets if they are above their true economic value, but they do not increase the book value if it is below economic value. Typical cost of capital for U.S. firms is 9%.
  5. “Sources of Value” answers “Where does the NPV come from?”, and explains it as a result of how competitive forces play out. The technique quantifies the advantages that a project is expected to have compared with a typical competitor (i.e. the “me too” player).
  6. A ‘me too’ player has a small negative NPV because it does not have any particular advantages.
  7. The value that would be earned by a typical player is a measure of the attractiveness of the sector. The better the return of a typical player, the more attractive the sector must be (analysed using Porter’s five forces model). In a very good sector, a ‘me too’ player will earn its cost of capital and have a zero NPV.
  8. A positive NPV project only results because you expect to be able to beat the competition and create value even when your competitors cannot (e.g. being able to sell more, sell at higher price, produce at lower cost).
  9. Identifying the sources of value allows a business to maximise the leverage of identified sources of value. E.g. if a company’s key source of value is in being able to build new plants for a lower capital cost than any other player, then it should build plants and let others operate, since it does not have any additional value in operations.
  10. Pay attention to industry cost curves.



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