Profiting from Franchise Value

Franchise Value Can Help a Company Build Wealth for Its Investors

The Power of Franchise Value in Business
A business with high franchise value can produce jaw-dropping results over long periods of time, making investors extraordinarily wealthy provided they paid a rational price for their ownership stake. Dennis K. Johnson / Getty Images

One of the things that makes certain businesses more successful than other businesses over long periods of time is the presence of franchise value.  A company with franchise value can often sell more measurement units of its products and services, resulting in higher revenue, and generate more net income applicable to common than other businesses in the same sector or industry.  As long as the capital structure is intelligently managed, businesses with high franchise value can more easily survive periods such as the Great Depression of 1929-1933 or the Great Recession of 2007-2009.

Though you may not be familiar with the concept, businesses with high franchise value have such distinctive characteristics that by the time you are done reading this article, you will probably be able to name five or ten of them off the top of your head.  Before we get into the details, though, let's define franchise value.

What Is the Definition of Franchise Value?

Franchise value does not refer to the traditional franchise business model, but instead is used to describe a company or brand that has such superior popularity it has extraordinary "mind share" among consumers; that, all else equal, it is the one they are going to reach for on the shelf or associate with a product.  In your own mind, you probably link bleach with Clorox, tissue with Kleenex, soda with Coca-Coca, Pepsi, or Dr. Pepper, soup with Campbell's, coffee with Starbucks or Dunkin Donuts, fast food with McDonald's, chocolate with Hershey's, Cadbury, or Lindt.

 If you're like most people around the world, you associate toothpaste with Colgate, theme parks with Disney, and sparkling water with Perrier.  There is something unique about each of these products that makes them stand out from others; that causes people to go out of their way to buy them for consumption or use even if they cost more than competitors.

 In fact, I once walked you through the power of the Hershey brand as an illustration, showing how it ultimately translated into investment profits.

How to Spot Franchise Value in a Business or Brand

The quickest way to determine if a business or brand has high franchise value is to ask yourself a series of questions.

  1. Am I willing to pay more for the brand (e.g., Hershey's) as opposed to another, cheaper brand (e.g., the generic chocolate bar)?
  2. If a store didn't have the brand in which I was interested, would I walk across the street to buy the product I wanted due to it being better or me having more trust in it?
  3. If I started a business in direct competition with this product or service, what are my chances of success? Would I be able to make a dent in its market share or is the product so firmly entrenched it would be difficult to wrestle away even a small portion?

Franchise value matters a great deal, especially for businesses where the stakes are high such as asset management companies.  In fact, it's something I had to think about for much of the past week.  The private asset management firm I'm launching to manage my family's money along with outside clients, Kennon-Green & Co., is in the process of comparing institutional custodians.

 It's an extensive process that involves a lot of comparisons and discussions.  Franchise value is something I have to think about because if two custodians are similar, there's an attraction for private clients in working with the one that has prestige or a sterling reputation that puts it ahead of its peers.

The Reason Companies with High Franchise Value Are Able to Make More Money

You may wonder as to the reason the owner of business possessing high franchise value tends to enjoy more prosperity than his or her counterpart operating a commodity-type business. The reason is simple: if a product or service has strong consumer demand and affinity, the company that manufactures or offers that product can raise prices to offset increased labor, production, inflation, and other costs.

 Alternatively, for alternate business models, it can achieve such economies of scale that it is able to reduce its prices below what competitors can comfortably sustain, still earn hefty profits, and drive others out of business. The company that does not have franchise value is forced to compete on a price or service basis, which it may not be capable of doing depending upon the specific economics of a sector, industry, or market.  For the business without franchise value, this can be a disaster, particularly in an industry with high operating leverage.  The major airlines are a good illustration.

Regardless of the Franchise Value a Business Possesses, the Price You Pay for Your Ownership Stake, and the Terms on Which You Acquire It, Still Determine Your Investment Results Over the Long-Run

Due to the laws of mathematics, the return you realize on an investment is absolutely dependent upon the price you paid. Paying too high a price for any asset in relation to its conservatively estimated intrinsic value moves the investor out of the realm of investment and into speculation. 

That said, time and time again history has shown that when an investor has a chance to buy a great business with a tremendous amount of franchise value, he or she may want to seriously considering foregoing the wait for a steep discount and, instead, acquiring it whenever it is trading at or near a fair price.  Owning a company that is capable of producing sustainable high returns on equity is one of the great joys in life.  Given a long stretch of compounding, it can be life changing.  I'd go so far as to suggest a good motto, given reasonable valuation, might be, "When it doubt, invest in the excellent business."