A compete or buy forecast is the best measure of competitive advantage when the optimal buyer is a competitor firm in the same market as the firm with goodwill. Click here for a description of optimal buyers. For any potential buyer who already owns an established firm this quantification of comparative advantage reduces to the two alternative ways to acquire new customers clients, or patients (CCPs):
Most competitor firms recognize that local or regional market have built in constraints such that the best course of action is to develop a firm with the capacity to service a targeted number of CCPs. Even absent these market constraints, a potential buyer may decide that it is best to limit CCP growth to a targeted level that can be sustained over an extended period of time. The operating strategy is two-fold: if the firm is operating at the targeted level do not seek CCP growth beyond replacement of CCPs who leave. If the firm is currently operating below targeted levels compete for new CCP or buy a firm with goodwill that can give immediate access to CCP to arrive at the target. Once the target is reached do not seek added growth. In thinking about acquiring new CCPs by buying a firm with goodwill, a potential buyer assumes that any CCPs lost will be replaceable with new CCPs. I will use examples to illustrate the impact of the alternative strategies to gain new CCP.
Example. Suppose we have a plumbing firm that has 100 customers that can be transferred to a competitor plumbing firm. Suppose this buyer has a targeted capacity to serve exactly 400 customers and currently has 300 customers. Suppose further that the competitive market can replace any customers lost through attrition but there is no cost effective way to gain 100 more customers through direct competition. The only way to gain the 100 desired more customers is to acquire them as part of an equity transfer. In this situation the Maximum Competitive Advantage (MCA) forecasts the upper bound amount of difference in discretionary earnings (DE) between competing versus buying the plumbing company. Click here for a description of the MCA. Click here for a description of DE.
Example. Let’s say that market conditions are different in the local plumbing market. Suppose the total market is increasing in size and/or the buyer’s competitive position is improving and there is a way for the firm to gain additional customers through competition. Let’s say that over the next five years a buyer could expect to gain 20 customers per year. Again I emphasize that I am speaking of net customers gained. At the end of the five years the firm will seek no more customers beyond those needed to replace lost ones. Under these conditions the buyer’s DE from acquiring the firm is less than the DE derived utilizing the MCA computation. In this case the comparative advantage is the difference between the DE that a buyer could realize by buying the firm and having immediate access to 100 customers and the DE that they would realize by waiting five years to accumulate the desired total number of targeted customers. To illustrate this I begin with a computation of the MCA assuming a twenty year life with attrition and a DE rate of $500 per customer per year:
Using the equation to compute the MCA, we have an MCA of just under $310,000. This is the maximum DE that could be extracted from the customer base. In order to assess the impact of having the option to gain additional customers through competition, I perform a side-by-side forecast of expected DE under both options. In this scenario the buyer does not need to reflect attrition because I am assuming that any customers lost are replaced by new customers. Here is the side by side analysis:
You can see that the comparative advantage of buying the company is quite a bit lower than previously computed without taking into account the ability to successfully compete for new customers. This COB forecast is a lower value because the net DE advantage to the buyer only exists for the next four years. Under our assumed rate of growth through competition after four years and forward there is no DE differential between the options. The advantage of buying the firm only exists for this period of time and no rational buyer would pay more than this amount despite the fact that the acquired customer base will generate DE for many years after this point.
We can quantify the COB comparative advantage as follows:
COBPA = Compete or Buy comparative advantage of acquiring the firm’s transferrable customer base for a unique Potential Acquirer (PA).
DE= Discretionary Earnings in dollars earned per customer per period i.
Bi* = the number of additional customers unadjusted for attrition derived from the SC’s transferred customer base in period i if they buy the SC
Ci* = the number of net customers available through competition unadjusted for attrition available to the PA in period i if they compete with the SC.
i = the period starting in the first year after the acquisition of the firm.
Δt = the last period i for which Bi* > Ci*.
PVi = time value of money factor for period i. This is a pure time value unadjusted for risk.
This COB equation should be used to compute the comparative advantage only under the assumption that the buyer can replace any customers lost with new customers and only when the buyer has a maximum ceiling on the customers that it is capable and willing to service. A few other points need to be stressed. First, like the MCA forecast, the COB forecast does not represent the value of a rational bid for the equity of the firm with goodwill. The COB is always lower than the MCA and represents the maximum comparative advantage to the buyer under the assumed market conditions. Bidding the full COB amount would leave the buyer with no benefit from acquiring the company. Thus the COB is an upper bound value. Second, the COB forecast can be applied to employee buyers but in most circumstances it will not be the most useful measure of comparative advantage. This is due to the fact that in most markets competing for CCPs starting with next to no CCP base is not the best alternative for employees. The better measure of comparative advantage is differential compensation which I describe on this page.
Copyright 2018 Michael Sack Elmaleh