“In the old legend the wise men finally boiled down the history of mortal affairs into a single phrase, ‘this too will pass’. Confronted with a like challenge to distil the secret of sound investment into three words, we venture the motto, ‘MARGIN OF SAFETY’.”
Ben Graham – The Intelligent Investor
I talk a lot about having a margin of safety when making investment recommendations. In today’s volatile investment world, it is the key to preserving and growing your wealth. In bull markets you can get away with a lack of discipline on the valuation front. In a post credit crisis world characterised by monetary disorder, you don’t have that luxury. The aim of this report is to show you how I apply this margin in relation to the Warren Buffett valuation methodology I use.
The concept of the margin of safety simply refers to the difference between a company’s share price and its intrinsic value. Valuations are subjective and are only as good as the assumptions you make.
So when buying shares in a company, factoring in a margin of safety between a company’s valuation and its share price is the key to limiting downside risk. A margin of safety can take a number of forms. At its most basic, it represents a discount between price and value.
If you calculate a company’s intrinsic value to be $1 per share and the share price is 70 cents, then the difference between actual value and market price is substantial. In other words, there is a decent margin of safety. So if you’re assumptions are a tad optimistic and the company’s prospects take a turn for the worse, the margin of safety affords you some protection. But a margin of safety can also be represented by a company’s growth prospects.
If a company’s profitability is expanding, so is its intrinsic value.
In this case, you do not necessarily need to buy at a deep discount to value to have a margin of safety. The methods I use are best shown through some examples. Depending on your knowledge, these examples may seem easy or difficult to understand. If difficult, go through them a few times slowly as the logic is pretty simple.
If you understand the rationale behind the examples, you’ll be well ahead of the majority of investors in understanding how companies grow or diminish value.
Before looking at some examples, you’ll want to know important measurements of quality and value – Return on Equity (ROE) and price-to-book value (P/B). I often talk about the relationship between ROE and the P/B value. A high ROE usually means a high P/B value and vice versa.
Why? Well, consider that ‘equity’ is another word for net assets or ‘book value’. The equity of a company represents the shareholders’ investment.
So the return you’re getting on this investment, the ROE, is all important.
Now, companies don’t simply trade at their equity, or book value. Some trade at a discount to book (P/B < 1) while others trade at a premium (P/B > 1). It is the ROE that determines the magnitude of the premium or discount. A highly profitable company, as represented by
a high ROE, would see investors willing to value the company well above its equity value.
You’ll see how this works below.
Growing intrinsic value
In the table below, we show a basic example of how a company’s intrinsic value can grow by reinvesting earnings and maintaining a consistently high return on those reinvested earnings.
|Year 1||Year 2||Year 3|
In Year 1 the company starts with an equity value of $100m. It generates a 50% return on that equity and has a dividend payout ratio of 50%. The subjective input we use is a required rate of return, or discount rate, of 10%. (We use 10% for simplicity in this example)
With these inputs, you can now provide an estimate of intrinsic value.
To do this you first need to work out the price-to-book value. While the actual P/B calculation is a little more complex for companies that retain some or all of their earnings, to keep things simple you obtain the P/B value by dividing the ROE, 50%, by the required rate of return, which is 10%.
This gives a P/B value of 5. Multiplying the book, or equity value of the company by 5 gives us the company’s intrinsic value, $500m (5x equity value of $100m).
(In these examples, the P/B value represents what the P/B should be based on the inputs. The actual or market P/B number will be different depending on the share price)
You can see from the table that if the company maintains a 50% ROE on a growing equity base, its intrinsic value will continue to grow strongly. In such a case the margin of safety is the company’s high rate of return on reinvested capital.
Here is the important thing to consider and the real benefit of investing in companies that can maintain high rates of return on their equity:
As an investor, you receive the $25m in dividends and benefit from the $25m of retained earnings. But because of the high ROE of the company, the $25m of retained earnings turns into $125m of market value (due to the P/B ratio of 5x). That’s how companies create value and it’s what makes share price rises sustainable.
In reality though, achieving consistently high returns on equity on a growing equity base is very difficult. Only quality companies can manage it.
I based one of my recent recommendations on this type of margin of safety. The company in question has achieved a consistently high ROE on a growing equity base. The margin of safety included a small discount to value plus the expectation that the firm would maintain these strong rates of return on increasing equity.
Declining intrinsic value
Consider the example where a company starts out with a very high ROE but it falls each year. We show this example in the table below. In the space of two years this hypothetical company suffers a decline in their ROE from 50% to 30%.
|Year 1||Year 2||Year 3|
This leads to a decline in the P/B ratio so $1 of retained earnings in Year 3 is producing $3 of market value, compared to $5 of market value in Year 1.
This example is similar to the real experience of many smaller companies. Starting out with high rates of return leads management to get all gung-ho and pursue ‘growth’. This can lead to overpaying for acquisitions or just buying a company with poorer economics, all of which leads to diminished profitability.
Growth is a much overused word in investment markets.
When the management of your company start talking about it, look to the evidence to see if it’s profitable. If ROE is declining sharply, they’re stuffing things up.
A margin of safety in this circumstance would be buying at a discount to value. Then, when evidence emerges that management is pursuing a value destructive growth path, you should simply sell. Over the longer term a margin of safety will not protect your capital from this scenario.
This is also a good example of why ‘growth’ companies can be bad investments, especially as the company grows larger
When you buy a company that is already priced to generate 50% ROE, it needs to be a very high quality company to maintain this growth.
However, the probability is that it won’t, so we tend to be wary of very profitable smaller companies that don’t have a long track record.
Stuck in the doldrums
Here we show an example of a company generating very low returns, either because of bad management or bad assets, but usually a combination of the two.
|Year 1||Year 2||Year 3|
With ROE of just 5%, the intrinsic value of this company would be just 0.5x its book value (obtained from dividing 5% by the required rate of return of 10%).
This means the company is turning every dollar of retained earnings into 50 cents of market value. Not a good result. Where’s the margin of safety here? Either by buying at a big discount to value or having some reason to believe that profitability will improve over the years.
Going from 5% to 20% ROE would do wonders for intrinsic value and share price performance, but turning a dud business around is no easy task.
Considering the above examples of how a company creates or destroys value, the following quote from Warren Buffett is revealing.
“Time is the enemy of the poor business and the friend of the great business. If you have a business that’s earning 20%-25% on equity, time is your friend. But time is your enemy if your money is in a low return business.”
Warren Buffet – 1998 Berkshire Annual Meeting
In other words, if you think a company can generate healthy, consistent returns on equity, time can be an effective margin of safety.
If those returns are consistently low, time will compound your misery.
When looking for companies to recommend, I take into account all these different factors. A margin of safety, especially in today’s uncertain and volatile markets, is as important as ever to consider.
As Ben Graham said, it is the essence of sound investing.
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