What it means
Valuation theory says that a share price has two building blocks. The first is the value of the company's current earnings if they simply continued without growth, which is earnings divided by the required rate of return.
The second is the franchise value, which is the extra worth arising from opportunities to invest at returns above the required rate. Dividing the franchise value by earnings gives the franchise P/E, and adding the base P/E gives the total P/E.
Companies with strong brands, patents, networks or customer loyalty can invest new money at high returns, so they have a high franchise P/E. Companies in competitive commodity businesses have little or none, and their P/E sits close to the base figure.
The idea is useful because it explains why two firms with the same earnings can trade on very different multiples. It also tells you where to focus when questioning a valuation: if most of the price is franchise value, the share depends on the company continuing to find high-return opportunities.
If those opportunities fade, the franchise portion can disappear quickly. The base P/E is the reciprocal of the required return, so a 10% required return gives a base P/E of 10 times.
If the share trades on 18 times earnings, then 8 times of the multiple is franchise value. A rise in interest rates lifts the required return, lowers the base P/E and tends to cut the franchise value of companies whose growth lies far in the future.
As with most valuation models, the answer depends on assumptions that are hard to measure, especially the required return and the growth of future opportunities. Treat the result as a way to frame the question rather than a precise measurement.
Analysts use it to challenge whether a premium multiple is justified by durable advantages.
In practice
Real-world examples.
Example
An analyst compares a branded consumer goods company on 22 times earnings with a generic packaging firm on 11 times. With a required return of 9%, the base P/E is about 11 for both. She concludes that the first company's extra 11 times comes from its brand and pricing power.
Example
A portfolio manager sees that a software company's franchise P/E makes up two thirds of its total multiple. He asks whether its customers will keep paying high prices and whether competitors can copy the product. He decides to hold a smaller position than the index weighting.
Example
A finance team prepares a presentation for the board about a possible acquisition. The target trades on 16 times earnings with a base of 10 times. The team argues that the price already includes 6 times earnings of franchise value, so the buyer should be careful about paying a further premium.
Formula
Calculation
Base value = Earnings per share / Required return
Franchise value = Share price - Base value
Franchise P/E = Franchise value / Earnings per share
Suppose a company earns $5.00 per share, investors require a return of 10%, and the shares trade at $90. The base value is 5.00 / 0.10 = $50, which is a base P/E of 10 times.
The franchise value is 90 - 50 = $40, and the franchise P/E is 40 / 5.00 = 8 times. The total P/E is 90 / 5.00 = 18 times, made up of 10 times for the existing business and 8 times for the franchise.Case study
Seen in the real world.
Crestline Beverages is a fictional listed drinks company with earnings of $2.00 per share and a share price of $40. The analyst, Naomi, wanted to understand how much of the price relied on the brand.
With a required return of 8%, the base value was 2.00 / 0.08 = $25, so the franchise value was 40 - 25 = $15. The franchise P/E was 15 / 2.00 = 7.5 times, out of a total P/E of 20 times.
In this illustrative case, a new competitor launched a cheaper product and Naomi cut her estimate of the brand's pricing power. She reduced the franchise value to $8, giving a fair value of 25 + 8 = $33, which was below the market price, so she advised clients to reduce their holdings.
Watch out
Common mistakes.
- Treating the franchise P/E as a figure reported in company accounts, when it is a theoretical split calculated by analysts.
- Using an unrealistic required return, which changes the base value and the franchise value dramatically.
- Assuming a high franchise P/E means a good investment, when it only shows that much of the price depends on future opportunities.
Questions
People also ask.
What is the base P/E?
It is the P/E a company would have if its earnings simply continued with no growth, calculated as one divided by the required return.
What creates franchise value?
It comes from advantages that allow a company to invest at returns above its cost of capital, such as strong brands, patents and loyal customers.
Why does franchise value fall when interest rates rise?
Higher rates raise the required return, which lowers the present value of distant growth, so the franchise part of the multiple is hit hardest.
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