The Difference Between a Franchise and a Business
Warren Buffett mentions that an economic franchise arises from a product or service that:
(1) Is needed or desired;
(2) Is thought by its customers to have no close substitute; and
(3) Is not subject to price regulation.
If all three conditions are present, the company will be able to increase its prices regularly and earn higher rates of return on capital. This can be achieved even without requiring additional capital.
A franchise is also more tolerant of inept management. They can reduce the franchise’s profitablity, but they are unlikely to kill the franchise.
For a business, Buffett is of the opinion that it will be able to earn exceptional profits only if it is a low-cost operator or if supply of its product or service is tight.
And in the real world, tightness in supply usually does not last long.
If management is good, a company might be able to keep costs low for a much longer time, but they will always face the possibility of a competitive attack.
And unlike a franchise, poor management can kill a business.
Based on these reasons, a franchise and a business should be valued differently.