The margin of safety principle is a fundamental part of value investing. Indeed, you could go so far as to say that without understanding this principle, it is not possible to follow a value strategy.
That being said, just by buying a stock that is trading below book value could qualify as buying with a margin of safety. However, as most experienced value investors will tell you, it is often not enough just to find the stocks trading below book value. Following this strategy can often lead you into value traps. There is usually a reason why stocks are trading below their book value per share and if you do not understand why, you could have a very negative surprise further down the line.
If a company is earning less that its cost of capital, then its shares deserve to trade below book value, as the firm is technically shrinking.
Placing a Number on Value
Calculating a company’s intrinsic value or producing an estimate of intrinsic value is essential if you want to avoid falling into a value trap.
Intrinsic value is an estimate of the value of a particular business based on the value of the firm’s cash flows. By focusing on cash flows alone, the value investor protects themselves to some extent from falling into disastrous value traps.
Warren Buffett (Trades, Portfolio) provides one definition of intrinsic value in Berkshire’s Owner’s Manual. He writes:
“Let’s start with intrinsic value, an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”
The brilliant Aswath Damodaran takes this definition of intrinsic value a step further, stating that:
“It is the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth and risk…At its core, if you stay true to principles, a discounted cash flow model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk. Even a book value approach is an intrinsic valuation approach, where you are assuming that the accountant’s estimate of what fixed and current assets are worth is the true value of a business.”
It is fundamental to understand the difference between intrinsic value and book value. Moreover, it is vital to understand that book value and intrinsic value are not related and in some cases, book value can actually be higher than intrinsic value. Once again, Berkshire’s Owner’s Manual gives an excellent example of why valuing a business like Berkshire Hathaway in the early years was more complicated than just computing the company’s net asset value.
“…in 1964 we could state with certitude that Berkshire’s per-share book value was $19.46. However, that figure considerably overstated the company’s intrinsic value, since all of the company’s resources were tied up in a sub-profitable textile business…Today, however, Berkshire’s situation is reversed: Now, our book value far understates Berkshire’s intrinsic value, a point true because many of the businesses we control are worth much more than their carrying value.”
Calculating a Company’s Intrinsic Value
When it comes to calculating a company’s intrinsic value, the preferred method is usually the discounted cash flow analysis.
Using the DCF analysis has both advantages and disadvantages. When used correctly, with an appropriate margin of safety built into all the figures, the valuation metric can be extremely helpful. However, when overly optimistic numbers, growth rates and a lower than average discount rate is applied, the DCF calculation can throw out an estimate of intrinsic value that is far above what the actual business is worth.
When putting together assumptions for business growth when calculating a DCF, it is essential to be extremely skeptical. Estimated cash flows two, three or five years in advance are never going to be 100% correct because they are estimates and it is important to understand that there will be both an upside and downside to these estimates.
Just because a business has been able to grow earnings and cash flow at 15% per annum for the last five years does not make it a certainty that this growth will continue.
It is also imperative to use a conservative discount rate in the DCF computation.
The discount rate can be thought of as the interest rate you require for taking on the risk of owning the stock. The more confident you are about a business's future cash flow, the lower the discount rate can be.
Most of the value investors I have encountered do not use a discount rate of less than 10%, which adds yet another layer of safety into growth estimates.
The Margin of Safety
The margin of safety principle compliments the conservative calculation of intrinsic value perfectly. As a calculation of intrinsic value can never be 100% perfect, the margin of safety gives you a cushion, so that even if you are 20% off your estimate of intrinsic value you still stand to make a profit.
For example, say that you calculate the intrinsic value of company X as being $100 a share, if you look for a margin of safety of 50% and by in that $50 a share, even if the stock peaks at $80 before earnings start to stagnate, a possible upside of 60% is still available.
This is only a rough back of the envelope calculation, but it still illustrates the point.
Mohnish Pabrai (Trades, Portfolio) looks for a 50%, or more, discount to intrinsic value when investing with a 2 to 3-year time horizon. Even if the stock only rises to his estimate of intrinsic value, a potential return of 100% over two to three years is available. If the intrinsic value increases, then clearly the gains will be greater. This discipline has helped Pabrai return over 500% for investors since his fund’s inception during 2000 through to 2013.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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