What is an appropriate margin of safety?

Even among value investors, there is ongoing disagreement concerning the appropriate margin of safety.



Some highly successful investors increasingly recognize the value of intangible assets.

Some highly successful investors, including Buffett, have come increasingly to recognize the value of intangible assets - broadcast licenses or soft-drink formulas, for example - which have a history of growing in value without any investment being required to maintain them.  Virtually all cash flow generated is free cash flow.



The problem with intangible assets, is that they hold little or no margin of safety. 

The most valuable assets of Dr Pepper/Seven-Up, Inc., by way of example, are the formulas that give those soft drinks their distinctive flavours.  It is these intangible assets that cause Dr Pepper/Seven-Up, Inc., to be valued at a high multiple of tangible book value.  If something goes wrong - tastes change or a competitor makes inroads - the margin of safety is quite low.



Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection from loss.  

Tangible assets usually have value in alternate uses, thereby providing a margin of safety.  If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated, receivables collected, leases transferred, and real estate sold.  If consumers lose their taste for Dr Pepper, by contrast, tangible assets will not meaningfully cushion investors' losses.

Asset-Based Valuation

Asset-Based Valuation uses market values of a company's assets and liabilities to determine the value of the company as a whole.

Asset based valuation works well for:

• Companies that do not have a significant number of intangible or "off-the-book" assets, and have a higher proportion of current assets and liabilities.
• Private companies, especially if applied together with multiplier models.
• Financial companies, natural resource companies and companies that are been liquidated.

Asset-based valuation may not be appropriate when:

• Market values of assets and liabilities cannot be easily determined.
• The company has a significant amount of intangible assets.
• Asset values are difficult to determine (e.g., in periods of very high inflation).
• Market values of assets and liabilities significantly differ from their carrying values.

Two pictures of value: An asset value and an earnings power value.

Mechanically Doing a Valuation 

1.  Doing an asset valuation

Now, doing an asset valuation is just a matter of working down the balance sheet. 

• As you go through the balance sheet, you ask yourself what it costs to reproduce the various assets.
• Then for the intangibles list them like the product portfolio and ask what will be the cost reproducing that product portfolio. 

2.  Doing an Earnings power valuation

For the EPV, you basically have to calculate two things:  

• You have to calculate earnings power which is the current earnings that is adjusted in a variety of ways.
• You divide the normal earnings by the cost of capital.

There is an assumption in an earnings power value and part of it is being careful about what earnings are.  This is just a picture of what some of those adjustments look like.

• You have to adjust for any accounting shenanigans that are going on, you have to adjust for the cyclical situation, for the tax situation that may be short-lived, for excess depreciation over the cost of maintenance capital expense (MCX).
• And really for anything else that is going on that is causing current earnings to deviate from long run sustainable earnings.
• So valuation is calculated by a company’s long-run sustainable earnings multiplied by 1/cost of capital.  

 

 

What you have got then is two pictures of value: 

 

1. You have got an asset value  (AV)

2. You have got an earnings power value  (EPV)

 

 

And now you are ready to do a serious analysis of value.

 

If the picture looks like case A (AV > EPV), what is going on assuming, you have done the right valuation here? 

• What it means is say you have $4 billion in assets here that is producing an equivalent earnings power value of $2 billion.
• What is going there if that is the situation you see? It has got to be bad management. 
• Management is using those assets in a way that cannot generate a comparable level of distributable earnings.
• If it is an industry in decline, make sure you haven’t done a reproduction value when you should be doing a liquidation value. 

Notes from video lecture by Prof Bruce Greenwald

http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

Warren Buffett on Economic Goodwill (Intangible asset)

WARREN BUFFETT ON ECONOMIC GOODWILL

This is what Warren Buffett calls economic good will which he explained in 1983 like this:

‘[B]usinesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.’

Using by analogy, one of the favorite examples of Warren Buffett, take two separate companies. Company A has a net worth of $100,000, $40,000 of which is net tangible assets and $60,000 of which is intangible (brand name, goodwill, patents etc). Company B has the same net worth but $90,000 its assets are tangible. Each company earns $10,000 a year.

• So Company A is earning $10,000 from tangible assets of $40,000 and Company B is earning $10,000 from tangible assets of $90,000.

If both companies wanted to double earnings, they might have to double their investment in tangible assets. 

• For Company A to do this, it would have to spend $40,000 to add $10,000 of earnings. 
• For Company B to do this, it would have to spend another $90,000 to add $10,000 to earnings. 

All other things being equal, Company A would have better future prospects of increase in real earnings than Company B.

THE REAL PROFITABILITY OF A COMPANY

For these reasons, Warren Buffett has said that, in calculating the real profitability of a company, there should be no amortisation of economic goodwill. Does the Gillette brand name actually decrease in value each year? Of course not.

The thoughts of both Graham and Warren Buffett are worth consideration. Book value is another ingredient in the investment equation.

Benjamin Graham and Warren Buffett appear to have differences in importance on tangible and intangible assets.

The assets of a company can be either tangible or intangible and, on this point, Benjamin Graham and Warren Buffett appear to have differences in importance.

WHAT BENJAMIN GRAHAM SAID ABOUT INTANGIBLE ASSETS

‘Earnings based on these intangibles [eg goodwill] may be even less vulnerable to competition than those which require only a cash investment in productive facilities.

'Furthermore, when conditions are favorable, the enterprise with the relatively small capital investment is likely to show a more rapid rate of growth.

Ordinarily it can expand its sales and profits at slight expense and therefore more rapidly and profitably for its stockholders than a business requiring a large plant investment per dollar of sales.’ Emphasis added.

HOW WARREN BUFFETT LOOKS AT INTANGIBLE ASSETS

This last comment of Graham has importance for Warren Buffett, who seems to really like companies with valuable, and sometimes irreplaceable, goodwill. 

To Warren Buffett, it is this intangible good will, an asset that continually produces profits without the need to spend money on maintenance, upgrading or replacement, that adds value to a company. 

Consider what it is that is most important in producing profits for Coca Cola: its name and recipe, or the various factories that produce the drink.

http://www.buffettsecrets.com/book-value.htm

WHAT IS BOOK VALUE?

WHAT IS BOOK VALUE?

The book value of a company is generally considered its net worth; the book value per share would be the net worth of a company divided by the number of shares outstanding.

BENJAMIN GRAHAM DEFINITIONS

There is a need, in considering the book value of a company share, to know what certain terms mean - and who better to explain them than the doyen of investment analysis, Benjamin Graham. His definitions are:

Tangible assets: Assets either physical or financial in character eg plant, inventory, cash, receivables, investments.

Intangible assets: Assets which are neither physical nor financial in character. Include patents, trademarks, copyrights, franchises, good will, leaseholds and such deferred charges as unamortised bond discount.

Graham took the view in Security Analysis that intangible assets should not be taken into account when calculating book value; hence, in this sense, book value per share would be the same as net tangible assets per share (NTA) as opposed to net assets per share (NA).

So, the assets of a company can be either tangible or intangible and, on this point, Benjamin Graham and Warren Buffett appear to have differences in importance.

How much should you pay for a business? Valuing a company (2)

Asset value

An obvious starting point for valuing a company is to look at the asset base of that organisation. On this basis the company would be worth its net asset value. There are some limitations to this approach:

Book value - Accountants usually value fixed assets at what they cost, depreciated to reflect the reducing value as items are worn out in use. Book value may not be an accurate reflection of the real value.

• This can apply when land and buildings were bought some time ago, and have grown in value; or 
• if the value of these assets has reduced significantly since purchase, due to new technologies. 
• There may also be a factor that has previously been ignored, such as environmental issues. Disposal or land remediation costs could wipe out any asset value.

Normally a company will have a fixed asset register that lists all its assets, and the current depreciated book value of those assets. A similar register might also exist for its other assets.

Working capital - Again, we must understand whether these items are accurately stated.

• Stock (inventory) is usually valued by accountants at what it cost. This may be far more than we can sell it for, especially if it is out of date. 
•  Debtors (receivables) is money owed to us by customers. How much of this might be bad debt (i.e. invoices that may never get paid)? 
•  Creditors (payables) is money we owe our suppliers. How much has our company avoided paying to improve its cash flow?

Intangible assets - This can take the form of

• goodwill (the difference between what we pay for an acquisition and what the assets are valued at) or 
• capitalised costs (such as research or start-up costs).

As there are no physical assets to underwrite these, the net assets may be overstated if these elements are high.

Investments - There might be some investments in other companies, which accountants will value at what was paid for them, rather than their realisable value in the market.

Unstated assets - Accountants usually put no value in the books on such things as people, brands, intellectual property, market position, forward order book etc. This means that the net asset figure alone might seriously understate the company value. This can apply especially in service-based businesses that have few tangible assets.

Also read:

Valuing a company (1)

Valuing a company using Asset Value (2)

Valuing a company using Multipliers (3)

Valuing a company using Market Capitalisation (4)

Valuing a company using Non-Financial Measures & Balanced Scoreboard (5)

Valuing a company using Cash Flows (6)

Book Value (Net Asset Value)

Synonyms:
Net asset value
Book value
Balance sheet value
Tangible-asset value
Net worth

= Total value of a company's physical and financial assets minus all its liabilities.

It can be calculated using the balance sheets in a company's annual and quarterly reprots.

From total shareholders' equity, subtract all "soft" assets such as goodwill, trademarks, and other intangibles.

Divide by the fully diluted number of shares outstanding to arrive at book value per share.