104 The Business of Value InvestingSoft Pillow an earnings value of $ 100 million (earnings value 1/
cost of capital of 10 percent).
Soft Pillow has $ 50 million in assets, which includes both tan-
gible and intangible assets. A potential competitor will look at this
company and realize that for an investment of $ 50 million, it, too,
can command an earnings value of $ 100 million. And if the market
assigns Soft Pillow a value of $ 120 million, the gap is wider, which is
even more of an inducement for competitors.
So what happens next? A new company will put up $ 50 million
and start making similar pillows, so now Soft Pillow earns only $ 7
million. It now has an earnings value of $ 70 million. A second com-
petitor will be induced by the opportunity to invest $ 50 million in
a company that has an earnings value of $ 70 million. The process
continues until earnings for Soft Pillow reach $ 5 million, at which
point there is no excess profi t to be made. Soft Pillow, a good com-
pany, resolves to earn only its cost of capital and no more. Sure,
commodity companies could tinker with their products to differen-
tiate them, but so will everyone else in the long run. In the end,
you ’ re back where you started.
The Franchise Value
The last example illustrates how having no competitive advantage
will slowly erode a business ’ s profi ts. Franchise - type businesses,
however, are extremely valuable. Simply defi ned, a franchise exists
where a company benefi ts from barriers to entry that keep poten-
tial competitors away. A strong franchise virtually insures that if
competitors enter, they will operate at a severe disadvantage. In
1987, Warren Buffett and Charlie Munger invested $ 1 billion
from Berkshire Hathaway ’ s cash pile into Coca - Cola Company. At
the time, this investment represented more than 20 percent of
Berkshire ’ s book value! You won ’ t fi nd a more dominant franchise
than Coca - Cola. If someone offered you $ 1 billion to go out andCH006.indd 104CH006.indd 104 9/2/09 6:58:08 PM9/2/09 6:58:08 PM