As many of you know, Ben Graham developed the concept of margin of safety decades ago. The insight and wisdom of his thinking still provide meaningful guidance today. As with any powerful tool, it leverages our understanding, but can also be misused. When I began to use and implement this concept early in my career, I made many mistakes of interpretation in the process. I began to think of margin of safety as a guaranteed low ball price that would represent the downside risk. I believe this is a common mistake that many new investors might encounter.
Apollo Group (APOL) provides a good example of this tendency. APOL has a long record of growth of both revenue and profits going back to the mid nineties. Investors have been rewarded for the company’s success - the shares are up approximately 2500% over the period of 15 years (this includes the recent sell-off).
Apollo shares began the price decline about two years ago when the risk of regulatory action against the for-profit educators became very real. Quick side note – the risk had been prevalent long before, but only recently has it materialized as a substantial problem. Along the way, the stock began to appear on many value oriented screens – and for good reason. While the company continued to post healthy gains in revenue, profits, and cash flow, the shares got cheaper and cheaper. The balance sheet looked strong with a huge cash surplus and low amounts of debt.
The valuation appeared compelling from many angles - even before the recent drop. If we think about margin of safety – we are simply trying to estimate a fair price and then buy at a discount to that price. We can price off of earnings, book value, cash flow, revenue…the list is large. APOL would be considered cheap by any of these measures. The discounted cash flow method (DCF) can be useful in determining margin of safety. Personally, I don’t use it to forecast valuation, I use it to gauge current market expectation of the offering share price. As you might guess, the market was awarding little to no growth expectation to the shares when the stock traded at about $50 per share. If we were to insert a fairly conservative 5% growth rate into our assumption – the result would be a 25% margin of safety into the current price. If we boosted that growth to 10% - a 40% margin would result. A 25% to 40% margin of safety is compelling (although I realize many value investors prefer 50%). Either way it appeared that the shares offered a favorable risk / reward tradeoff with little downside. This doesn’t even factor in the company was holding $6.50 net cash per share on the balance sheet.
Fast forward to today and the shares have declined almost 30% from our conservative downside risk estimate. So it’s important to understand margin of safety for what it is and is not. It is a discount to our estimated intrinsic value – an intrinsic value that is based on assumptions open to error. It is not a protective floor to our estimates. It can be breached and then some.