The 25 tools referenced in “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment” begin in chapter five, but before launching into them, author Sven Carlin waved a warning flag.
He pointed out the market often values businesses in an extremely irrational way, whether that’s too much or too little. Because of that, value investors can find opportunities—if they can properly value businesses. But don’t expect to value businesses too precisely, instead think in terms of a range of values, which leads into the following.
Tool 1: Use a range of values
When you make investing decisions, use a range of values rather than one precise valuation. Carlin explained that many “beautiful mathematical models” aim to provide precise target prices, but the models are flawed because they contain assumptions that constantly change. As for formulas, he cited the words of Warren Buffett (Trades, Portfolio), “Stay away from anything that has a Greek letter in it.” He then went on to say, “These days, all you need to be a value investor is common sense, willingness to do lots of research and a computer.”
The key to value investing, he wrote, is to buy when the current stock price falls below “your most pessimistic” estimate of its value. Having a long-term perspective will help, too, as it provides a more stable platform for calculating real business values. Carlin then outlined four steps for determining value:
- Net present value analysis.
- Liquidation value.
- Stock market value.
- Value to a private owner.
Tool 2: Net present value analysis
Net present value refers to the discounted value of all future cash flows a company is expected to produce. Note the word “discounted” in the definition; it is the reasonable assumption that a dollar held today is worth more than a dollar promised in the future, because of inflation and other factors that could deflate future values (more below).
Now, no one knows what the future holds, so we cannot assign a precise discount rate, but we can try to use the right kinds of assumptions. To explain, he used Tesla TSLA as an example:
- In 2017, the company had a market valuation of more than $50 billion based on estimates of future revenue that stretched into the hundreds of billions of dollars. It could become the new Apple AAPL based on market cap.
- But conservative investors would look at its actual debt rather than its possible revenue. Value investors would ask what might happen should a recession slow down car sales or should the solar panel business not become profitable. If either or both happens, there is a risk of bankruptcy, making this stock too risky for a value investor.
Net present value calculations begin with a discount rate, as noted above. Carlin offered the example of a mining company rated at the high end because problems of all kinds can turn up between conception and the start of actual mining—technical, political, social and more. When setting a discount rate for the mining industry, Carlin opted for one as high as as 20%.
On the other hand, a low rate would be set for a blue-chip company, especially one with a moat, because it has a history and there is minimal risk it will experience setbacks in the near and medium term. In that case, Carlin recommended a discount rate equal to the risk premium on a 10-year Treasury bill, plus a stock risk premium. Essentially, the Treasury bill is riskless (0%) and investors need only add a few percentage points for the stock risk premium. In recent history, the stock premium has ranged between 1.2% (1999) and 6.45% (1979).
To calculate net present value, we start with the formula for calculating the present value of a future cash flow, which is “PV = FV/(1+i)t.” In this formula, “PV” is the present value of the future cash flow; “FV” is the actual future estimated cash flow, “i” is the discount rate and “t” is the time of the future period.
With the present value established, it is possible to calculate the net present value, using the formula “NPV = PV – current stock price.” To explain, he used the imaginary example of a company with 10-year cash flows growing at 7% a year, while its net present value uses a 5% discount rate (for the sake of simplicity, he said no final value would be calculated):
The bottom line summarizes the outcome:
- The sum of the present value is $1,038 (adding up PV values for each of the 10 years).
- The cost of the stock is $800.
- Therefore, this investment would have a net present value of $238 (PV – stock price); that’s a positive valuation, so this stock would be worth further consideration.
How far into the future should you project? Carlin wrote that he considered 10 years a good period, and anything that happened beyond that would be a potential bonus. Broadly speaking, the shorter the period, the larger the margin of safety (because uncertainty increases over time).
Also worth consideration: business stability, business moat and profitability. The stronger these elements, the lower the discount rate can be. For example, a strong moat suggests competitors will not be able to take away market share or force a price war.
Carlin offered a couple of other scenarios to illustrate the relationship between cash flow growth and the discount rate. The first was a 10-year projection, assuming no cash flow growth and a 10% discount rate:
- The sum of the present value is $614.
- The cost of the stock is $800.
- Therefore, this investment would have a negative net present value of $185.54 and would not normally be considered a good investment candidate.
The second alternative scenario envisaged a 10-year period with no growth, where a recession starting in year three pushes earnings down and the discount rate is 10%:
As the table shows, the summed present value is only $477, while the price is $800, leading to a negative net present value of $323. Again, this would normally exclude the stock from further consideration.
Finally, Carlin reiterated the future cannot be accurately predicted and these numbers are estimates, higher or lower according to the discount rate and other assumptions. Regardless, they provide reasonable estimates worth far more than just random guesses or the market’s predictions.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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