Navigating the Art of Business Valuation: Book Notes from Seth Klarman's "Margin of Safety"

The Business value of a stock cannot be precisely determined. As Keynes once said, “It is better to be roughly right than precisely wrong”. Worst of all, business value is not only imprecisely knowable, but it also changes over time depending on economic and market conditions.

Reported book value, earnings, and cash flow are, after all, only the best guesses of accountants who follow a fairly strict set of standards and practices designed more to achieve conformity than to reflect economic value. Projected results are less precise still. You cannot appraise the value of your home to the nearest thousand dollars.

The precisions with DCF, NPV and IRR calculations can give us a false sense of security. After all, they are really only as accurate as the cash flow assumptions that were used to derive them. The advent of the computerized spreadsheet has exacerbated this problem, creating the illusion of extensive and thoughtful analysis, even for the most haphazard of efforts.

Typically, investors place a great deal of importance on the output, even though they pay little attention to the assumptions. “Garbage in, garbage out” is an apt description of the process. 

Margin of Safety

By Seth Klarman

Three Valuation Techniques

1. Net present value (NPV) analysis

NPV is the discounted value of all future cash flows that a business is expected to generate. 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. 

2. Liquidation value analysis

The expected proceeds if a company were to be dismantled and the assets sold off. Breakup value (aka Sum-of-the-Parts), 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.

3.Stock Market Valuation

The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value.

Difficulties of Growth-Oriented Investors

If you are a growth oriented investor, don’t overpay for mediocre businesses and be lured into making overly optimistic projections based on temporarily robust results.

Growth oriented investors often become overconfident with their ability to predict the future.

There will also be a significant impact on valuation if there is even a small difference in one’s estimation of annual growth rates.

Growth tied to population increases is considerably more certain than growth stemming from changes in consumer behavior, such as the conversion of whiskey drinkers to beer.

Investors should be cautious when predicting changes in consumer behaviours as the reaction of customers to price increases is always uncertain.

On the whole it is far easier to identify the possible sources of growth for a business than to forecast how much growth will actually materialize and how it will affect profits.

Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb. Virtually everything must go right, or losses may be sustained. Conservative forecasts can be more easily met or even exceeded. Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom.

The Discount Rate Choice

Investors with a strong preference for present over future consumption or with a preference for the certainty of the present to the uncertainty of the future would use a high rate for discounting their investments.

Other investors may be more willing to take a chance on forecasts holding true; they would apply a low discount rate, one that makes future cash flows nearly as valuable as today’s.

The appropriate discount rate for a particular investment depends not only on an investor’s preference for present over future consumption but also on his or her own risk profile, on the perceived risk of the investment under consideration, and on the returns available from alternative investments.

Investors tend to oversimplify; the way they choose a discount rate is a good example of this. A great many investors routinely use 10 percent as an all-purpose discount rate regardless of the nature of the investment under consideration. Ten percent is a nice round number, easy to remember and apply, but it is not always a good choice.

The underlying risk of an investment’s future cash flows must be considered in choosing the appropriate discount rate for that investment. A short-term, risk-free investment (if one exists) should be discounted at the yield available on short-term U.S. Treasury securities, which, as stated earlier, are considered a proxy for the risk-free interest rate.

Low-grade bonds, by contrast, are discounted by the market at rates of 12 to 15 percent or more, reflecting investors’ uncertainty that the contractual cash flows will be paid.

*There is considerable academic debate concerning whether short-term or long-term interest rates should be applied. My view is to match the timing of the cash flows to the maturity of the U.S. Treasury security. (i.e. if the cash flow is in 5 years, use a 5 year treasury yield)

Once future cash flows are forecast conservatively and an appropriate discount rate is chosen, present value can be calculated. In theory, investors might assign different probabilities to numerous cash flow scenarios, then calculate the expected value of an investment, multiplying the probability of each scenario by its respective present value and then summing these numbers.

In practice, given the extreme difficulty of assigning probabilities to numerous forecasts, investors make do with only a few likely scenarios. They must then perform sensitivity analysis in which they evaluate the effect of different cash flow forecasts and different discount rates on present value.

If modest changes in assumptions cause a substantial change in net present value, investors would be prudent to exercise caution in employing this method of valuation. 

Takeover Multiples

In the conglomerate boom of the late 60s, companies with extraordinarily high share prices used their overvalued equity as currency to buy other businesses. When overvalued conglomerate shares slumped, takeover multiples followed suit.

Valuing securities based on the prices paid in takeovers that use securities as currency is circular reasoning, since higher security prices become a self-fulfilling prophecy. Investors relying on conservative historical standards of valuation in determining private-market value will benefit from a true margin of safety, while others’ margin of safety blows with the financial winds.

My personal rule is that investors should value businesses based on what they themselves, not others, would pay to own them. At most, private-market value should be used as one of several inputs in the valuation process and not as the exclusive final arbiter of value.

On Sum of The Parts

In attempting to value a company’s interest in an unrelated subsidiary or joint venture, for example, investors would certainly consider the discounted anticipated future cash flow stream (net present value), the valuation of comparable businesses in transactions (private-market value), and the value of tangible assets net of liabilities (liquidation value). Investors would also benefit from considering stock market value, the valuation of comparable businesses in the stock market. While the stock market’s vote, especially over the long run, is not necessarily accurate, it does provide an approximate near- term appraisal of value.

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 be on the side of conservatism, adopting lower values over higher ones unless there is strong reason to do otherwise. True, conservatism may cause investors to refrain from making some investments that in hindsight would have been successful, but it will also prevent some sizable losses that would ensue from adopting less conservative business valuations.

On Liquidation Value

Even when an ongoing business is dismantled, many of its component parts are not actually liquidated but instead are sold intact as operating entities. Breakup value is one form of liquidation analysis; this involves determining the highest value of each component of a business, either as an ongoing enterprise or in liquidation. Most announced corporate liquidations are really breakups; ongoing business value is preserved whenever it exceeds liquidation value.

Calculating Liquidation Value

When no crisis is at hand, liquidation proceeds are usually maximized through a more orderly winding up of a business. In an orderly liquidation the values realized from disposing of current assets will more closely approximate stated book value.

• Cash, as in any liquidation analysis, is worth one hundred cents on the dollar.
• Investment securities should be valued at market prices, less estimated transaction costs in selling them.
• Accounts receivable are appraised at close to their face amount.

The realizable value of inventories — tens of thousands of programmed computer diskettes, hundreds of thousands of purple sneakers, or millions of sticks of chewing gum — is not so easily determinable and may well be less than book value. The discount depends on whether the inventories consist of finished goods, work in process, or raw materials, and whether or not there is the risk of technological or fashion obsolescence. The value of the inventory in a supermarket does not fluctuate much, but the value of a warehouse full of computers certainly may. Obviously, a liquidation sale would yield less for inventory than would an orderly sale to regular customers. 

Using Net-net working capital in liquidation

In approximating the liquidation value of a company, some value investors, emulating Benjamin Graham, calculate “net-net working capital” as a shortcut. Net working capital consists of current assets (cash, marketable securities, receivables, and inventories) less current liabilities (accounts, notes, and taxes payable within one year).

Net-net working capital is defined as net working capital minus all long-term liabilities. Even when a company has little ongoing business value, investors who buy at a price below net-net working capital are protected by the approximate liquidation value of current assets alone. As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all its liabilities, and still distribute proceeds in excess of the market price to investors.

Beware of Reflexivity

Stock price can at times significantly influence the value of a business. Investors must not lose sight of this possibility.

If, for example, an undercapitalized bank has a high stock price, it can issue more shares and become adequately capitalized, a form of self-fulfilling prophecy.

This phenomenon is a wild card, a valuation factor not determined by business fundamentals but rather by the financial markets themselves.

This reminds me of FRC and SVB where a fall in stock price brings more media attention, causing more investors and depositors to flee, which slumps the stock price even more.

On the Earnings, Book Value, and Dividend Yield

1. Earnings

EPS does not attempt to measure the cash generated or used by a business. And as with any prediction of the future, earnings are nearly impossible to forecast.

Corporate managements are generally aware that many investors focus on growth in reported earnings, and a number of them gently massage reported earnings to create a consistent upward trend. A few particularly unscrupulous managements play accounting games to turn deteriorating results into improving ones, losses into profits, and small profits into large ones.

Even without manipulation, analysis of reported earnings can mislead investors as to the real profitability of a business. Generally accepted accounting practices (GAAP) may require actions that do not reflect business reality.

By way of example, amortization of goodwill, a noncash charge required under GAAP, can artificially depress reported earnings; an analysis of cash flow would better capture the true economics of a business.

By contrast, nonrecurring gains can boost earnings to unsustainable levels, and should be ignored by investors.

Most important, whether investors use earnings or cash flow in their valuation analysis, it is important to remember that the numbers are not an end in themselves. Rather they are a means to understanding what is really happening in a company.

*While cash flow is less distorted by accounting quirks than earnings, it too can be manipulated if a company is so inclined. Cash flow can be temporarily increased, for example, by a reduction in capital spending; however, this eventually leads to deterioration of the business.

2. Book Value

Sometimes historical book value (carrying value) provides an accurate measure of current value, but often it is way off the mark. Current assets, such as receivables and inventories, for example, are usually worth close to carrying value, although certain types of inventory are subject to rapid obsolescence. Plant and equipment, however, may be outmoded or obsolete and therefore worth considerably less than carrying value. Alternatively, a company with fully depreciated plant and equipment or a history of write-offs may have carrying value considerably below real economic value.

Inflation, technological change, and regulation, among other factors, can affect the value of assets in ways that historical cost accounting cannot capture. Real estate purchased decades ago, for example, and carried on a company’s books at historical cost may be worth considerably more. The cost of building a new oil refinery today may be made prohibitively expensive by envi- ronmental legislation, endowing older facilities with a scarcity value. Aging integrated steel facilities, by contrast, may be technologically outmoded compared with newly built minimills. As a result, their book value may be significantly overstated.

Reported book value can also be affected by management actions. Write-offs of money- losing operations are somewhat arbitrary yet can have a large impact on reported book value. Share issuance and repurchases can also affect book value. Many companies in the 1980s, for example, performed recapitalizations, whereby money was borrowed and distributed to shareholders as an extraordinary dividend. This served to greatly reduce the book value of these companies, sometimes below zero. Even the choice of accounting method for mergers — purchase or pooling of interests — can affect reported book value.

3. Dividend Yield

Stocks should simply not be bought on the basis of their dividend yield. Too often struggling companies sport high dividend yields, not because the dividends have been increased, but because the share prices have fallen. Fearing that the stock price will drop further if the dividend is cut, managements maintain the payout, weakening the company even more.

In A Nutshell: Navigating the Art of Business Valuation

Business valuation is a complex process yielding imprecise and uncertain results. Many businesses are so diverse or difficult to understand that they simply cannot be valued. Some investors willingly voyage into the unknown and buy into such businesses, impatient with the discipline required by value investing. Investors must remember that they need not swing at every pitch to do well over time; indeed, selectivity undoubtedly improves an investor’s results. For every business that cannot be valued, there are many others that can. Investors who confine themselves to what they know, as difficult as that may be, have a considerable advantage over everyone else.