The Growth With Value Podcast Alistair Cowley

Download PDF Analysis of Flight Centre Travel Group (FLT) HERE.

Download PDF Analysis of Lovisa (LOV) HERE.

Download PDF Analysis of Nick Scali (NCK) HERE.

Over the last nine episodes we covered a number of different topics which together form the basis of valuing a business’ intrinsic value. I began the Investor Education Series in Episode 2 with a brief Overview of my Investment Process. My basic investing concept is to find the best businesses out there and increase my understanding of these businesses so I am ready to invest with conviction if or when the time comes that they trade at or below their respective intrinsic values.

I outlined the process I undertake to find these wonderful businesses over the next eight episodes, where in Episode 3 I explained how I use a stock filter to find the companies that meet my criteria, then in Episode 4 I ran through how to utilise an investment checklist. Episodes 5-9 covered the fundamentals of valuing a business and Episode 10 we looked at the importance of applying a Margin of Safety to your investments.

Thanks very much for listening to my short Investor Education Series and I hope I have been able to help you to better understand a few key fundamental points behind valuing a business. From here you can continue to build your knowledge, which is a never ending process, and begin to make intelligent, fundamentally based,  investment decisions.

Today we will talk about the Margin of Safety. Basically, the Margin of Safety is the difference between the value of a business, its Intrinsic Value, and the price which you pay for that business, its market price. It is different from the Discount Rate and can vary, depending on the perceived risk of the investment. The Margin of Safety is there to; absorb the impact of any unforeseen events that may adversely affect the business or the market in general, minimise the impact of any miscalculations made during the valuation process, allow for small declines in the company’s future earnings power, as well as taking into account your own risk tolerance. It is imperative not to use the Margin of Safety to justify the purchase of undervalued stocks if their fundamentals aren’t sound.

As a general observation of the market, investors are happy to buy when prices are high, and they see less perceived risk in the market. Then in turn, when the market crashes and prices plummet, they perceive this situation as high risk and sell. Logically, the margin of risk has now greatly reduced as prices are much lower than they were. If you were to purchase quality businesses at this time, your Margin of Safety has greatly increased.

To further increase your Margin of Safety (but not just by purchasing at a lower price) you should stick to businesses that you know and understand. By doing this your evaluations and future earnings predictions will have more meaning and certainty behind them.

To know what Margin of Safety to apply can be difficult. Generally, the riskier the investment the higher the Margin of Safety required. I like to set my desired Margin of Safety after first completing my checklist. I will give each checklist item a rating from 0 to 5, with 5 being excellent, 3 being average, 1 substandard and 0 being non-existent. From here I sum my checklist results to give me an overall rating and then divide that rating by the sum of the total points available. For example, say we have 30 checklist items; each item can achieve a maximum score of 5 points, which would give a total of 150 points (30 checklist items x 5 points for each item). If, after conducting my analysis of the business and giving each checklist item a rating, I arrive at a total of 125 points, I would divide my score of 125 by 150, which equates to 83.3% and by inverting that number I get a Margin of Safety of 16.7%, or 100% - my 83.3% checklist score which equals 16.7%. I will then discount my calculated Intrinsic Value of a company by 16.7% which will equate to my preferred purchase price for that company. For example, if I have calculated the Intrinsic Value of a company to be about $10 per share, I will then discount this price by 16.7% to give me my purchase price for that company, which is now $8.33.

As a side note, my minimum required Margin of Safety is set to 20%, so in this circumstance I would use the greater of the two and apply a 20% Margin of Safety, resulting in a lower purchase price of $8.00 instead of the previously stated $8.33.

I believe this approach is a simple and relatively accurate way to assess a company’s risk and thus allowing me to incorporate a Margin of Safety into my Intrinsic Value calculation.

Welcome to Part B of the two part episode on Valuation Methods. In part A we ran through how to value a business using the Discounted Cash Flow model. This method can be used to value the majority of businesses, especially those that are expected to continue operating well into the future. Today we will take a look at the Liquidation Value of a business. Liquidation Value can be used to estimate the potential investment risk of holding a company, as it provides you with an estimated value you, as an investor, can expect to receive if the company was to go out of business and its assets liquidated. Given shareholders are the last to be paid in the event of a liquidation, it is often the case that they will not receive any compensation for their investment in the business, resulting in a 100% loss. If however the Liquidation Value of the business is say $100 for example and you paid $200 for the business, then you can at least hope to get back $0.50 on each dollar you invested, or in other words a 50% loss total, which is obviously much better than a 100% loss.

The Liquidation Value is a method Benjamin Graham developed to estimate a value for the assets of a business if it was to be liquidated. It is basically the Tangible Book Value of a business but adjusted to better represent the liquidation value of its assets. When a business is trading near its Liquidation Value, it obviously has some problems. It would be amiss of someone to expect a struggling business to be able to sell its assets and inventory at Book Value, or the value quoted on the company’s Balance Sheet. This inability for a company to sell its assets at Book Value could be due to the company’s products not being as desirable or in such high demand as it used to, or the industry in which the business operates becoming obsolete. Unless you have the ability to analyse each asset and individually estimate the current market value of the assets, you can instead refer to estimates of the recovery rates for each asset class as determined by Benjamin Graham in his extensive research.