Case 018Company analysis and valuationCore
A payroll software company has earned a 28% return on capital against a 12% cost of capital for ten years, with 4% annual customer churn. What are its competitive advantages and barriers to entry, can it sustain 18% revenue growth, and how much is the excess return worth?
1The situation
Kanakdhara Payroll Software sells cloud payroll and statutory compliance software to Indian mid-sized firms. It has Rs 500 crore of invested capital and has earned a 28% return on it for ten years, against a cost of capital of 12%. It has 40,000 customers paying about Rs 1.5 lakh a year each, revenue of Rs 600 crore, and loses 4% of customers a year.
Management guides to 18% revenue growth for the next decade, with prices rising about 5% a year. The case sheet estimates 300,000 firms in its target market.
2Your task
Name the competitive advantages and barriers, test whether 18% growth is sustainable, and value how long the excess return lasts.
Quick check
Which number is the strongest evidence of a moat here?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Its moat is switching costs, visible in 4% churn, and the question is how long 28% returns take to fade, not whether they last forever. Payroll software holds salary history, statutory filings and bank links, so leaving is risky. Growing 18% needs about 6,552 new customers a year and would take it from 13% to 43% of its market in ten years, so growth should slow. The excess return is worth Rs 328 crore if it fades over 15 years, Rs 128 crore over five.
Step 1What are the competitive advantages and barriers to entry?
Start from what the customer would have to do to leave. A payroll system holds years of salary history, tax deductions and statutory filings, and is wired to the bank, the attendance system and the auditors; switching risks paying 2,000 staff late or filing wrongly, so customers rarely switch. That is a switching costThe cost, effort and risk a customer faces in moving to a rival, which lets a business keep customers without matching every rival price., and 4% churn, an average customer life of 25 years, is its footprint. A second barrier is compliance knowledge: labour and tax rules vary by state and change often, and keeping up is a fixed cost a new entrant must pay before its first sale. A family doctor who has treated you for twenty years has the same advantage over a new clinic with a lower fee.
Step 2What could erode it?
Three things to name. A large HR or accounting software provider bundling payroll free with a product the customer already uses; cloud entrants pricing low to win new firms, which never face a switching cost; and a government portal that simplifies statutory filing, removing part of the compliance barrier. Switching costs protect the existing base far better than they win new customers, which matters for the growth question.
Step 3Can it sustain 18% revenue growth?
Split growth into price and customers. With prices rising 5%, customers must grow 12.4% a year. Net adds of 4,952 a year plus 1,600 lost to churn means about 6,552 new customers every year, 16.4% of today's base, and it rises each year. After ten years Kanakdhara would have about 128,525 customers, 43% of the 300,000 firms in its market, up from 13%. Growth also needs investment: at a 28% return, 18% growth requires reinvesting 64% of profit, leaving free cash flow of about Rs 50 crore on Rs 140 crore of operating profit. Eighteen per cent for five years is plausible; for ten it assumes winning new firms as easily as it keeps old ones.
| Growth check | Working | Result |
|---|---|---|
| Customer growth needed | 1.18 / 1.05 - 1 | 12.4% |
| Customers lost a year | 4% of 40,000 | 1,600 |
| New customers needed a year | 4,952 net + 1,600 | 6,552 |
| Market share after ten years | 128,525 of 300,000 | 43% |
| Reinvestment needed | 18% / 28% | 64% of profit |
Step 4How do you value how long the excess return lasts?
Value the economic profitOperating profit after tax minus a charge for the capital used: invested capital times the cost of capital., the return above the cost of capital. On Rs 500 crore, a 16-point spread is Rs 80 crore a year. If competition pushes the return to 12% in a straight line over five years, that stream is worth about Rs 128 crore today; if the moat stretches the fade to fifteen years, about Rs 328 crore, over two and a half times as much. The difference, about Rs 199 crore, is the value of the moat's width, and it is what the price of the stock is really arguing about. This holds the capital base flat to isolate the fade; growth at returns above 12% would add to both figures.
Where candidates lose it
Candidates list generic moats, brand, network effects, scale, without tying any of them to a number. The strongest answer names the one moat the data supports, switching costs, and points to the 4% churn that proves it.
The second loss is treating a high return as permanent or as doomed. The useful question is how fast it fades, because that single assumption can more than double the value of the excess return.
What the interviewer asks next
- Churn rises to 8% after a larger rival bundles payroll free. What happens to the fade and the value?
- How would you check whether the 28% return is flattered by capitalised software costs?
- Would you rather own Kanakdhara at 18% growth and 28% returns, or a rival at 30% growth and 15% returns?
- What would you ask the company about price increases on existing customers?
Asked at Morningstar, Equity Research, Anonymous interview candidate in, 2023 (Wall Street Oasis): what are the areas of competitive advantage does this company have? Do they have any barriers to entry?
Company names and figures are illustrative.