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Valuing a company: the margin of safety

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Published

2 years ago

May 3, 2022

CLare Dominic

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Valuing a company: the margin of safety, Evaluating a business is as much an art as it is a science. Although we can use the most complex mathematical models, the valuation of a company depends largely on the projection that we make of its future free cash flows. However, as Yogi Berra would have said, “it is difficult to make forecasts, especially those concerning the future“.

This is why the exercise of evaluating a company requires a great deal of humility and a comfortable margin of safety.

I recommend two habits that could help you increase your margin of safety and reduce the mistakes you will make in evaluating potential investments.

In the first place, when you are evaluating a company, get into the habit of establishing a wide range of valuation. Establishing an accurate valuation, such as $48.76 for any security, is in my opinion a dangerous exercise that promotes a false sense of trust and security.

For our part, we establish three values for a society according to three possible scenarios: a pessimist, a realistic and an optimist. We then try to weight each of these assessments according to the probability we see for each scenario. So, for example, we could arrive at the valuation of a $40 security in a pessimistic scenario (say with a probability of 25%), $60 in a realistic scenario (50% probability) and $80 in an optimistic scenario (25% probability).

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In this example, we would arrive at a weighted valuation of $60 ((25% * $40) + (50% * $60) + (25% * $80)). But more importantly, we would have a valuation range between $40 and $80.

I would add that a good dose of caution is recommended in the exercise of the valuation of a stock, even in the optimistic scenario.

Once you have established this valuation range, allow yourself a good margin of safety by buying at a price significantly lower than your valuation. In the example above where the valuation range was between $40 and $80 and the weighted valuation was $60, what price would you be willing to pay for the security?

For my part, I would like to pay a price that will be as close as possible to $40. Ideally, as part of our management, we will attempt to obtain a discount of at least 20% compared to our weighted valuation. In the hypothetical case presented, we would be interested in buying at $50 or less.

At such a price, we would envision a potential return of 20% compared to our weighted valuation of the company. At $45, the stock would look even more attractive to us, as we would then envision a potential return of around 33% while our downside risk (based on our pessimistic scenario) would only be just over 10%.

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The second habit that will significantly reduce the risk of error is to bet exclusively on high-quality corporate securities (I will write on this subject in a future blog). By investing in a quality company whose business model is protected by high barriers to entry and which offers a high probability of continuing to grow in the long term, the importance of your initial assessment will decrease significantly over time.

Indeed, the company that succeeds in increasing its earnings per share at an attractive rate for several years will see its intrinsic value increase significantly during this period.

Let’s go back to our example of a hypothetical society. For example, suppose you made a valuation error initially by valuing it at $60 when its true value was $40. If this company succeeds in increasing its earnings per share by an average of 10% per year for subsequent years, it can be assumed that its intrinsic valuation will increase in parallel with its profits.

After two years, this value will probably have increased to $48.50. After five years, it will be about $64.50.