"The entrance strategy is actually more important than the exit strategy". – Eddie Lampert
"Plan before acting. Fight only when you know you can win." - Zhuge Liang
In the previous post on the Principles of Value Investing I introduced the concept of Margin of Safety and Intrinsic Value and answered the first of 5 questions that I posed:
(1) Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?
(2) How Do I Calculate the Value of a Stock?
(3) Why Not Pay the Fair Value for a business? Why Must I seek a Margin of Safety?
(4) How great a Margin of Safety do Value Investors generally demand?
(5) Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?
In today's post I will attempt to answer questions 2 to 4.
Q2: How Do I Calculate the Value of a Stock?
The important point to understand here is that calculating the Intrinsic Value of a business or stock is not an exact science. It is an estimate or a range between prices.
A simple example: Let's assume you are interested in purchasing a felafel stand. How would you calculate what price is a fair price you should pay for the business? Hopefully, you would look at 2 factors:
(i) Cashflow: You would try to assess how much cash the business will generate (cash flow) every year after all your expenses have been paid.
(ii) Growth Expectations: You will try to assess the growth potential of the business.
Now let's assume you do some research and discover that similar falafel stands in the area generate in their first year of operation an annual cashflow of $50,000, after all expenses have been paid. And let's assume that you discover that a similar falafel stand increased it's annual cashflow by 10% every year.
Would you pay $50,000 for the stand? Probably – as this means that you would earn back your initial $50,000 in one year. How about $100,000? Yeah, maybe. $200,000? Um, let me think about it. So you now have an estimate – in your opinion it is worth somewhere between $50,000 to $200,000.
If the seller of the falafel stand wants $1 million for it, you would immediately recognize that only a fool would pay such a price – even if there are hundreds of other fools paying similar prices for similar businesses elsewhere. On the other hand, if someone, for some reason offered to sell it to you at $25,000 – you would take a serious look at this deal.
In calculating the intrinsic value of stock, Value Investors apply a method called "Discounted Cash Flow" or DCF. The 2 main assumptions are free cash flow and growth. As much has been written by individuals far more capable than me, I will not go into the actual calcualtion or methodology of DCF. Instead allow me to point you to:
(1) Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?
(2) How Do I Calculate the Value of a Stock?
(3) Why Not Pay the Fair Value for a business? Why Must I seek a Margin of Safety?
(4) How great a Margin of Safety do Value Investors generally demand?
(5) Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?
In today's post I will attempt to answer questions 2 to 4.
Q2: How Do I Calculate the Value of a Stock?
The important point to understand here is that calculating the Intrinsic Value of a business or stock is not an exact science. It is an estimate or a range between prices.
A simple example: Let's assume you are interested in purchasing a felafel stand. How would you calculate what price is a fair price you should pay for the business? Hopefully, you would look at 2 factors:
(i) Cashflow: You would try to assess how much cash the business will generate (cash flow) every year after all your expenses have been paid.
(ii) Growth Expectations: You will try to assess the growth potential of the business.
Now let's assume you do some research and discover that similar falafel stands in the area generate in their first year of operation an annual cashflow of $50,000, after all expenses have been paid. And let's assume that you discover that a similar falafel stand increased it's annual cashflow by 10% every year.
Would you pay $50,000 for the stand? Probably – as this means that you would earn back your initial $50,000 in one year. How about $100,000? Yeah, maybe. $200,000? Um, let me think about it. So you now have an estimate – in your opinion it is worth somewhere between $50,000 to $200,000.
If the seller of the falafel stand wants $1 million for it, you would immediately recognize that only a fool would pay such a price – even if there are hundreds of other fools paying similar prices for similar businesses elsewhere. On the other hand, if someone, for some reason offered to sell it to you at $25,000 – you would take a serious look at this deal.
In calculating the intrinsic value of stock, Value Investors apply a method called "Discounted Cash Flow" or DCF. The 2 main assumptions are free cash flow and growth. As much has been written by individuals far more capable than me, I will not go into the actual calcualtion or methodology of DCF. Instead allow me to point you to:
(i) An excellent article from the Motley Fool.
(ii) Joe Ponzio's FWallStreet - Joe's blog is first class - extremely well written, a shining example of an individual bringing value to the market. Specifically look at the 4-part series on The Value of a Business that begins here. You can also download a very good DCF excel spreadsheet which Joee used on his analysis of JNJ here.
Q3: Why Not Pay the Fair Value? Why Must I seek a Margin of Safety?
"One of the hardest things to imagine is that you are not smarter than average" - Daniel Kahneman, New York Times "Why Both Bulls and Bears Can Act So Bird-Brained", March 30, 1997
You haven't been paying attention, have you? Calculating Intrinsic Value is not an exact science – it is estimation only that requires two assumptions – a forecast for annual cash flow in year 1 and an estimated growth rate. As these are only assumptions – they can be wrong (and often are). You need to leave some contingency in the event that your assumptions are wrong.
Warren Buffett refers to the field of construction and engineering where the Margin of Safety concept is applied daily:
"You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing." - The Superinvestors of Graham-and-Doddsville
In his 1974 Letter to Shareholders Buffett wrote:
"Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results."
"One of the hardest things to imagine is that you are not smarter than average" - Daniel Kahneman, New York Times "Why Both Bulls and Bears Can Act So Bird-Brained", March 30, 1997
You haven't been paying attention, have you? Calculating Intrinsic Value is not an exact science – it is estimation only that requires two assumptions – a forecast for annual cash flow in year 1 and an estimated growth rate. As these are only assumptions – they can be wrong (and often are). You need to leave some contingency in the event that your assumptions are wrong.
Warren Buffett refers to the field of construction and engineering where the Margin of Safety concept is applied daily:
"You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing." - The Superinvestors of Graham-and-Doddsville
In his 1974 Letter to Shareholders Buffett wrote:
"Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results."
This is why I have always said that Value Investors earn their money when they place a 'buy order' - not on the sell. The skill is in buying well.
And in his 1992 Letter to Shareholders he said it again:
“What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).....The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value...... If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.”
Q4: How great a Margin of Safety do Value Investors generally demand?
"If you understand a business and if you can see its future perfectly, then you obviously need very little in the way of margin of safety...Conversely, the more vulnerable the business, the larger the margin of safety you require." - Warren Buffett
As the Buffett quote suggests, the Margin of Safety that you give yourself is a function of to what extent you feel confident about forecasting a businesses cashflows and growth. Value Investors typically demand a margin of safety (or discount) of at least 30% (and sometimes as high as 50%) to calculated intrinsic value.
It is also worth noting that the greater the Margin of Safety that you give yourself, the lower the risk in losing your initial investment. The Partners at Tweedy Browne, a well-known Value Investing fund manager explains:
"One of the many unique and advantageous aspects of value investing is that the larger the discount from intrinsic value, the greater the margin of safety and the greater potential return when the stock price moves back to intrinsic value. Contrary to the view of modern portfolio theorists that increased returns can only be achieved by taking greater levels of risk, value investing is predicated on the notion that increased returns are associated with a greater margin of safety, i.e. lower risk."
"One of the many unique and advantageous aspects of value investing is that the larger the discount from intrinsic value, the greater the margin of safety and the greater potential return when the stock price moves back to intrinsic value. Contrary to the view of modern portfolio theorists that increased returns can only be achieved by taking greater levels of risk, value investing is predicated on the notion that increased returns are associated with a greater margin of safety, i.e. lower risk."
In Part 3 of Value Investing Principle #3, I will attempt to answer Question 5 and discuss what the industry refers to as 'Value Traps'.
"May you possess the Wisdom to see what the Market does not, and the Courage to act on it".
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