In 1991, Seth A. Klarman published “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.” This book outlined his thoughts and approach to investing.
In this article, I would like to share some passages that I have compiled from Chapter 8 (The Art of Business Valuation) of “Margin of Safety.” These passages focus on Seth Klarman’s three preferred methods of business valuation.
Before we jump full-force into these methods of business valuation, let’s start with an introductory quote from Mr. Klarman:
“To be a value investor, you must buy at a discount from underlying value. Analyzing each potential value investment opportunity therefore begins with an assessment of business value…. While a great many methods of business valuation exist, there are only three that I find useful.” (Margin of Safety, pg. 121)
The table below contains these three business valuation methods that Seth Klarman finds useful. This table also contains definitions for these valuation methods, some thoughts as to when it might be appropriate to use each valuation method, and some notes related to each valuation method. Following this table, I have also included some of Klarman’s related thoughts on business valuation and investing.
When to Use it
1. Net Present Value (NPV) Analysis
"NPV is the discounted value of all future cash flows that a business is expected to generate." (Margin of Safety, pg. 121)
Going concern value. "Net present value would be most applicable, for example, in valuing a high-return business with stable cash flows such as a consumer-products company; its liquidation value would be far too low. Similarly, a business with regulated rates of return on assets such as a utility might best be valued using NPV analysis." (Margin of Safety, pg. 135)
"A frequently used but flawed shortcut method of valuing a going concern is known as private-market value. This is an investor's assessment of the price that a sophisticated businessperson would be willing to pay for a business. Investors using this shortcut, in effect, value businesses using the multiples paid when comparable businesses were previously bought and sold in their entirety." (Margin of Safety, pgs. 121-122)
2. Liquidation Value
A) Liquidation Value is the "expected proceeds if a company were to be dismantled and the assets sold off" (Margin of Safety, pg. 122). B) "The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles, such as going-concern value, are not." (Margin of Safety, pg. 131)
"Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value." (Margin of Safety, pg. 135)
"Breakup value, one variant of liquidation analysis, considers each of the components of a business at its highest valuation, whether as part of a going concern or not." (Margin of Safety, pg. 122) "Most announced corporate liquidations are really breakups; ongoing business value is preserved whenever it exceeds liquidation value." (Margin of Safety, pg. 131) "Liquidation value is generally a worst-case assessment." (Margin of Safety, pg. 131)
3. Stock Market Value
Stock Market Value "is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market." (Margin of Safety, pg. 122)
"A closed-end fund or other company that owns only marketable securities should be valued by the stock market method; no other makes sense." (Margin of Safety, pg. 135)
"Less reliable than the other two, this method is only occasionally useful as a yardstick of value." (Margin of Safety, pg. 122)
Related Thoughts on Business Valuation & Investing:
1. "Each of these methods of valuation has strengths and weaknesses. None of them provides accurate values all the time. Unfortunately no better methods of valuation exist. Investors have no choice but to consider the values generated by each of them; when they appreciably diverge, investors should generally err on the side of conservatism." (Margin of Safety, pg. 122)
2. "Often several valuation methods should be employed simultaneously. To value a complex entity such as a conglomerate operating several distinct businesses, for example, some portion of the assets might be best valued using one method and the rest with another. Frequently investors will want to use several methods to value a single business in order to obtain a range of values. In this case investors should err on the side of conservatism, adopting lower values over higher ones unless there is strong reason to do otherwise." (Margin of Safety, pg. 135)
3. The Reflexive Relationship Between Market Price and Underlying Value: "A complicating factor in securities analysis is the reflexive or reciprocal relationship between security prices and the values of the underlying businesses. In The Alchemy of Finance George Soros stated, 'Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values.' In other words, Soros's theory of reflexivity makes the point that its stock price can at times significantly influence the value of a business. Investors must not lose sight of this possibility.... Reflexivity is a minor factor in the valuation of most securities most of the time, but occasionally it becomes important. This phenomenon is a wild card, a valuation factor not determined by business fundamentals but rather by the financial markets themselves." (Margin of Safety, pgs. 136-137)
4. "Not only is business value imprecisely knowable, it also changes over time, fluctuating with numerous macroeconomic, microeconomic, and market-related factors. So while investors at any given time cannot determine business value with precision, they must nevertheless almost continuously reassess their estimates of value in order to incorporate all known factors that could influence their appraisal." (Margin of Safety, pg. 118)
I hope this information on business valuation has been useful to you. I know it has been to me.