CHAPTER 14: THE MILLION DOLLAR QUESTION: HOW MUCH TO PAY FOR IT?

CHAPTER 14: THE MILLION DOLLAR QUESTION: HOW MUCH TO PAY FOR IT?

Previous Chapter
The Concept of Margin of Safety
Next Chapter

 
The common misconception about long term investment is to buy a good company and let the market take its course. Although this sounds logical, it may not guarantee success as it lacks another important factor – how much are we actually paying for the company? Buying a bad company at a good price will usually end up being a bad decision. But buying a good company at a bad price can be equally damaging. What investors should seek is buying a good company at a good price. So, what is this good price?
 
The Concept of Margin of Safety
 
One of the most talked about investment concept is without a doubt the concept of “Margin of Safety”. The concept was created by the legendary investor, Benjamin Graham.

Most experienced investors can easily quote you that the margin of safety approach is to invest in companies where the market value is lower than its intrinsic value.
 
But what is intrinsic value?

Intrinsic value is a subjective value – subjective in the sense that it differs between investors and analysts. The most common definition of intrinsic value used by analysts is that intrinsic value is represented by the book value of the company.

Book value of a company is the net tangible asset of the company, which is derived by taking the total tangible assets (i.e. excluding intangible assets such as goodwill) and deduct it with total liabilities.

However, as we can see from the market’s experience, in most cases, the price of the shares bears little correlation with the book value.

There too are investors who define margin of safety with the market’s target price of the securities that they are buying. Their view is the lower the current market price is from the market’s target price, the “safer” the investment is. Again, this view is not exactly correct.

In Benjamin Graham’s investment classic book Security Analysis, Second Edition, Benjamin Graham’s comments on the concept of Intrinsic Value was:
 

“The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security.

 It needs only to establish either that the value is adequate – e.g. to protect a bond or to justify a stock purchase – or else that the value is considerably higher or considerably lower than the market price.”[1]

[1] Graham, Benjamin. and Dodd, David L. 1934. Security Analysis. 2^nd ed. New York and London: McGraw-Hill.

 

There are two key points to Benjamin Graham’s statement.

First, the objective is not to determine the “exact” intrinsic value of the security.
 
Second, the analyst only needs to establish that the value is considerably higher or considerably lower than the market price. How can the analyst establish this? The only way that an analyst is able to achieve this is by understanding the nature of the business of the company.

In Graham’s second most prominent work (or the most, as some may argue), The Intelligent Investor, Graham summed up that the key to margin of safety is:
 

“Know what you are doing – know your business.”[2]

[1] Graham, Benjamin. 2003. The Intelligent Investor. New York: HarperCollins.

 
An experienced property investor will know when a bargain appears, as he or she is well versed in the value of properties that he or she is keen on. He or she may not know the exact worth of the properties, but he or she will definitely know when someone is willing to let go of the property at a bargain price. For one that is not in the property investment line, or lacks sufficient knowledge about it, they would not be able to differentiate between a bargain and a rip-off.

Similarly, an experienced mechanic will be able to tell if a second-hand car is worth the money. Their experience may not be able to tell him or her how much the car is worth, but from the experience he or she will know if the car is worth buying.

That is why in reality, it is difficult for one to pin-point exactly how much a company is worth.
 
In this chapter, we will discuss a few of the basic valuation methods that can be used in valuing a company. These methods only serve as a point of reference for investors to determine whether a company is trading at the investor’s own comfort level (i.e. margin of safety) or not. And I would like to re-iterate that in investment, one man’s meat can be another man’s poison. No two investors will have the same view and comfort level when investing.

Next week, we will explore the first commonly used valuation method, which is Price-to-Earnings, or PE, Ratio.

Previous Chapter  |   Chapter List    |   Next Chapter