Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

By David T. Larrabee and Jason A. Voss

Analysis and insights from top thought leaders on a pivotal topic in investing and asset management

Valuation is the cornerstone for investment analysis, and a thorough understanding and correct application of valuation methodologies are critical for long-term investing success. Edited by two leading valuation experts from CFA Institute, this book brings together the insights and expertise of some of the most astute and successful investment minds of the past 50 years. From Benjamin Graham, the “father of value investing,” to Aswath Damodaran, you’ll learn what these investment luminaries have to say about investment valuation techniques, including earnings and cash flow analysis.  

• Features the best thinking on valuation from the industry’s masters on the topic, supplemented with dozens of fascinating and instructive real-world examples
• Comprehensively discusses special valuation situations, such as real options, employee stock options, highly leveraged firms, corporate takeovers, and more
• Supplies you with the tools you need to successfully navigate and thrive in the ever-changing financial markets
• Is being produced with the full support and input of CFA Institute, the world’s leading association of investment professionals

 

• Language: English
• Publisher: Wiley
• Release date: Oct 9, 2012
• ISBN: 9781118417607

Book preview

INTRODUCTION

Valuation is the cornerstone for the edifice we call security analysis. The pioneering work in developing a rigorous theory for valuation was published in 1938 as The Theory of Investment Value by John Burr Williams. For reasons that I have never been able to understand, it was not until 1959, when Myron J. Gordon published his paper Dividends, Earnings, and Stock Prices in the Review of Economics and Statistics (where the now well-known Gordon model was put forth), that attention was finally directed to the seminal work of Williams’s 1938 piece. Perhaps it was the highly quantitative nature (for its time) of the original Williams work that deterred earlier interest; after all, in the early days finance and investments were largely descriptive fields of endeavor and devoid of quantitative analysis other than that related to accounting statements. Benjamin Graham and David Dodd published their first edition of Security Analysis in 1934, and the valuation work in that text was accounting based and did not contain the necessary theoretical underpinnings that Williams and then Gordon later developed. Security Analysis (ultimately six editions have been published) was considered the definitive work for investors until the late 1960s, when attention began to turn to more advanced methodologies that were consistent with an understanding of the theory of valuation. Graham himself was somewhat skeptical of Williams’s valuation theory, saying in his 1939 review (Journal of Political Economy, April 1939) that if investors can be persuaded to take a saner attitude toward stocks by Williams’s higher algebra, then he (Graham) would vote for it despite the hit-or-miss character embedded in the model’s assumptions.

Perhaps indirectly related, but of decided importance, to the development of valuation methodologies for security analysis were two papers that concentrated on portfolio analysis. Harry Markowitz published his now famous article Portfolio Selection (Journal of Finance, March 1952) that focused attention on the proper understanding of stock price variability and diversification. Bill Sharpe published his own path-breaking article, A Simplified Model for Portfolio Analysis (Management Science, January 1963), which built upon the earlier work of Markowitz and extended the understanding of equilibrium in security pricing. Both of these papers, although slow to be accepted in the practitioner’s toolkit until the 1970s, make a large contribution to our understanding of risk premiums for valuation models. Similarly, Martin Leibowitz, in his 1972 book with Sidney Homer titled Inside the Yield Book, brought valuation techniques into clear perspective for fixed-income investors and also provided fresh insight into the importance of discount rates used in common stock valuation models.

This compendium of valuation methodologies put together by Jason Voss, CFA, and David Larrabee, CFA, draws from publications sponsored by CFA Institute and its predecessors over many years and provides a robust review of the important literature that has evolved in the valuation field. Each of the pieces offers structure and insight into the complexities of valuation modeling and, in its own way, points to the joint importance of model design and input to the model’s variables. Models in and of themselves are critical in providing us with a framework for thought as it pertains to security pricing. They anchor us to the appropriate variables, their interaction with each other, and the resulting pricing sensitivities. But in the quest for making the models practical and useful to investors, the models themselves have become a necessary yet insufficient condition for success. Model inputs via the defined variables are the deciding factor, and it is here that the investor can distinguish himself or herself from the crowd. Unlike Graham and Dodd with their emphasis on historical accounting data, today’s successful investor needs to understand the uncertainties of the future and how the input variables will develop ex ante rather than simply taking the ex post observations. This can be a daunting task.

The economist Frank Knight in his book Risk, Uncertainty and Profit (1921) made a famous distinction that many in the investment profession seem to have forgotten but would be well served to remember. Knight pointed out that risk is a condition in which the outcomes are unknown but the probabilities are known with certainty. Throwing dice is an easy example of this risk case. Uncertainty, as Knight points out, is different from risk because the probabilities are not known with exactness and the outcomes are similarly not known. This notion of uncertainty is what we in the investment world are constantly grappling with in our models. We need to always remind ourselves that our probabilities are subjective, not objective, and flow from our analysis in establishing the ex ante input variables. Investors live in a world of uncertainty, not risk as defined by Knight, which is why the task is so daunting.

Valuation methodologies will continue to evolve with the passage of time and, correctly applied, will enable investors to cope more successfully with the inevitable uncertainties embedded in financial markets. The articles contained in this book should serve as an invaluable resource for understanding the contributions made by CFA Institute to this field.

Gary P. Brinson, CFA

PART I

VALUATION PERSPECTIVES: THEN AND NOW

Chapter 1 Two Illustrative Approaches to Formula Valuations of Common Stocks

Chapter 2 Seeking a Margin of Safety and Valuation

CHAPTER 1

TWO ILLUSTRATIVE APPROACHES TO FORMULA VALUATIONS OF COMMON STOCKS

a

Benjamin Graham

Two common-stock valuation approaches are examined in detail. The first approach considers company profitability, earnings growth and stability, and dividend payout. It derives an independent value of a stock that is then compared with the market price. In contrast, the second approach starts with the market price of a stock and calculates the rate of future growth implied by the market. From the expected growth rate, future earnings can be derived, as well as the implicit earnings multiplier in the current market price. Both approaches demonstrate that the market often has future growth expectations that cannot be derived from companies’ past performance.

Of the various basic approaches to common-stock valuation, the most widely accepted is that which estimates the average earnings and dividends for a period of years in the future and capitalizes these elements at an appropriate rate. This statement is reasonably definite in form, but its application permits of the widest range of techniques and assumptions, including plain guesswork. The analyst has first a broad choice as to the future period he will consider; then the earnings and dividends for the period must be estimated, and finally a capitalization rate selected in accordance with his judgment or his prejudices. We may observe here that since there is no a priori rule governing the number of years to which the valuer should look forward in the future, it is almost inevitable that in bull markets investors and analysts will tend to see far and hopefully ahead, whereas at other times they will not be so disposed to heed the rumble of a distant drum. Hence arises a high degree of built-in instability in the market valuation of growth stocks, so much so that one might assert with some justice that the more dynamic the company the more inherently speculative and fluctuating may be the market history of its shares.¹

When it comes to estimating future earnings few analysts are willing to venture forth, Columbus-like, on completely uncharted seas. They prefer to start with known quantities—e.g., current or past earnings—and process these in some fashion to reach an estimate for the future. As a consequence, in security analysis the past is always being thrown out of the window of theory and coming in again through the back door of practice. It would be a sorry joke on our profession if all the elaborate data on past operations, so industriously collected and so minutely analyzed, should prove in the end to be quite unrelated to the real determinants of the value—the earnings and dividends of the future.

Undoubtedly there are situations, not few perhaps, where this proves to be the rueful fact. But in most cases the relationship between past and future proves significant enough to justify the analyst’s preoccupation with the statistical record. In fact the daily work of our practitioner consists largely of an effort to construct a plausible picture of a company’s future from his study of its past performance, the latter phrase inevitably suggesting similar intensive studies carried on by devotees of a very different discipline. The better the analyst he is, the less he confines himself to the published figures and the more he adds to these from his special study of the company’s management, its policies, and its possibilities.

The student of security analysis, in the classroom or at home, tends to have a special preoccupation with the past record as distinct from an independent judgment of the company’s future. He can be taught and can learn to analyze the former, but he lacks a suitable equipment to attempt the latter. What he seeks, typically, is some persuasive method by which a company’s earnings record—including such aspects as the average, the trend or growth, stability, etc.—plus some examination of the current balance sheet, can be transmuted first into a projection of future earnings and dividends, and secondly into a valuation based on such projection.

A closer look at this desired process will reveal immediately that the future earnings and dividends need not be computed separately to produce the final value. Take the simplest presentation:

1. Past earnings times X equal future earnings.

2. Future earnings times Y equal Present Value.

This operation immediately foreshortens to:

3. Past Earnings times XY equal Present Value.

It is the XY factor, or multiplier of past earnings, that my students would dearly love to learn about and to calculate. When I tell them that there is no dependable method of finding this multiplier they tend to be incredulous or to ask, What good is security analysis then? They feel that if the right weight is given to all the relevant factors in the past record, at least a reasonably good present valuation of a common stock can be produced, one that will take probable future earnings into account and can be used as a guide to determine the attractiveness or the reverse of the issue at its current market price.

In this article I propose to explain two approaches of this kind which have been developed in a Seminar on Common-Stock Valuation. I believe the first will illustrate reasonably well how formula operations of this kind may be worked out and applied. Ours is an endeavor to establish a comparative value in 1957 for each of the 30 stocks in the Dow-Jones Industrial Average, related to a base valuation of 400 and 500, respectively, for the composite or group. (The 400 figure represented the approximate Central Value of the Dow-Jones Average, as found separately by a whole series of formula methods derived from historical relationships. The 500 figure represented about the average market level for the preceding twelve months.)

As will be seen, the valuations of each component issue take into account the four quality elements of profitability, growth, stability and dividend pay-out, applying them as multipliers to the average earnings for 1947–1956. In addition, and entirely separately, a weight of 20% is given to the net asset value.

The second approach is essentially the reverse of that just described. Whereas the first method attempts to derive an independent value to be compared with the market price, the second starts with the market price and calculates therefrom the rate of future growth expected by the market. From that figure we readily derive the earnings expected for the future period, in our case 1957–1966, and hence the multiplier for such future earnings implicit in the current market price.

The place for detailed comment on these calculations is after they have been developed and presented. But it may be well to express the gist of my conclusions at this point, viz.:

1. Our own formula valuations for the individual stocks, and probably any others of the same general type, have little if any utility in themselves. It would be silly to assert that Stock A is worth only half its market price, or Stock B twice its market price, because these figures result from our valuation formula.

2. On the other hand, they may be suggestive and useful as composite reflections of the past record, taken by itself. They may even be said to represent what the value would be, assuming that the future were merely a continuation of past performances.

3. The analyst is thus presented with a discrepancy of definite magnitude, between formula value and the price, which it becomes his task to deal with in terms of his superior knowledge and judgment. The actual size of these discrepancies, and the attitude that may possibly be taken respecting them, are discussed below.

Similarly, the approach which starts from the market price, and derives an implied growth factor and an implied multiplier therefrom, may have utility in concentrating the analyst’s attention on just what the market seems to be expecting from each stock in the future, in comparison or contrast with what it actually accomplished in the past. Here again his knowledge and judgment are called upon either to accept or reject the apparent assumptions of the marketplace.

Method 1. A Formula Valuation Based Solely on Past Performance in Relation to the Dow-Jones Industrial Average as a Group.

The assumptions underlying this method are the following:

1. Each component issue of the Dow-Jones Industrial Average may be valued in relation to a base value of the average as a whole by a comparison of the statistical records.

2. The data to be considered are the following:

a. Profitability—as measured by the rate of return on invested capital. (For convenience this was computed only for the year 1956.)

b. Growth of per-share earnings—as shown by two measurements: 1947–56 earnings vs. 1947 earnings, and 1956 earnings vs. 1947–56 earnings.

(It would have been more logical to have used the 1954–56 average instead of the single year 1956, but the change would have little effect on the final valuations.)

c. Stability—as measured by the greatest shrinkage of profits in the periods 1937–1938 and 1947–1956.

(The calculation is based on the percentage of earnings retained in the period of maximum shrinkage.)

d. Pay-out—as measured by the ratio of 1956 dividends to 1956 earnings. In the few cases where the 1956 earnings were below the 1947–56 average we substituted the latter for the former, to get a more realistic figure of current pay-out.

These criteria demonstrate the quality of the company’s earnings (and dividend policy) and thus may control the multiplier to be applied to the earnings. The figure found under each heading is divided by the corresponding figure for the Dow-Jones group as a whole, to give the company’s relative performance. The four relatives were then combined on the basis of equal weights to give a final quality index of the company as against the overall quality of the group.

The rate of earnings on invested capital is perhaps the most logical measure of the success and quality of an enterprise. It tells how productive are the dollars invested in the business. In studies made in the relatively normal market of 1953 I found a surprisingly good correlation between the profitability rate and the price-earnings ratio, after introducing a major adjustment for the dividend payout and a minor (moderating) adjustment for net asset value.

It is not necessary to emphasize the importance of the growth factor to stock-market people. They are likely to ask rather why we have not taken it as the major determinant of quality and multipliers. There is little doubt that the expected future growth is in fact the major influence upon current price-earnings ratios, and this truth is fully recognized in our second approach, which deals with growth expectations as reflected in market prices. But the correlation between market multipliers and past growth is by no means close.

Some interesting figures worked out by Ralph A. Bing show this clearly.² Dow Chemical, with per-share earnings growth of 31% (1955 vs. 1948) had in August 1956 a price-earnings ratio of 47.3 times 1955 earnings. Bethlehem Steel, with corresponding growth of 93%, had a multiplier of only 9.1. The spread between the two relationships is thus as wide as fourteen to one. Other ratios in Mr. Bing’s table show similar wide disparities between past growth and current multipliers.

It is here that the stability factor asserts its importance. The companies with high multipliers may not have had the best growth in 1948–55, but most of them had greater than average stability of earnings over the past two decades.

These considerations led us to adopt the simple arithmetical course of assigning equal weight to past growth, past stability, and current profitability in working out the quality coefficient for each company. The dividend payout is not strictly a measure of quality of earning power, though in the typical case investors probably regard it in some such fashion. Its importance in most instances is undeniable, and it is both convenient and plausible to give it equal weight and similar treatment with each of the other factors just discussed.

Finally we depart from the usual Wall Street attitude and assign a weight of 20% in the final valuation to the net assets per share. It is true that in the typical case the asset value has no perceptible influence on current market price. But it may have some long-run effect on future market price, and thus it has a claim to be considered seriously in any independent valuation of a company. As is well known, asset values invariably play some part, sometimes a fairly important one, in the many varieties of legal valuations of common stocks, which grow out of tax cases, merger litigation, and the like. The basic justification for considering asset value in this process, even though it may be ignored in the current market price, lies in the possibility of its showing its weight later, through competitive developments, changes in management or its policies, merger or sale eventuality, etc.

The above discussion will explain, perhaps not very satisfactorily, why the four factors entering into the quality rating and the fifth factor of asset value were finally assigned equal weight of 20% each.

The actual application of our illustrative method can now be explained by working through the figures for the first company in the group, Allied Chemical & Dye. Following are data used in computing the value of ACD relative to a 400 and a 500 valuation for the Dow-Jones Industrial Average:

In Table 1.1 we supply the valuation reached by this method for each of the 30 stocks in the Dow Jones Industrial Average. Our table includes the various quality factors, the average earnings, and the asset values used to arrive at our final figures.

TABLE 1.1 Formula Valuations of Dow-Jones Industrial Issues

In about half the cases these valuations differ quite widely from the prices ruling on August 5 last, on which date the D. J. Average actually sold at 500. Seven issues were selling at 20% or more above their formula value, and an equal number at 20% or more below such value. At the extremes we find Westinghouse selling at a 100% premium, and United Aircraft at about a 50% discount. The extent of these disparities naturally suggests that our method is technically a poor one, and that more plausible valuations could be reached—i.e., ones more congruous with market prices—if a better choice were made of the factors and weights entering into the method.

A number of tests were applied to our results to see if they could be improved by some plausible changes in the technique. To give these in any detail would prolong this report unnecessarily. Suffice it to say that they were unproductive. If the asset-value factor had been excluded, a very slight change would have resulted in favor of the issues which were selling at the highest premium over their formula value. On the other hand, if major emphasis had been placed on the factor of past growth, some of our apparently undervalued issues would have been given still larger formula values; for Table 1.1 shows that more of the spectacular growth percentages occur in this group than in the other—e.g., United Aircraft, International Nickel, and Goodyear.

It is quite evident from Table 1.1 that the stock market fixes its valuation of a given common stock on the basis not of its past statistical performance but rather of its expected future performance, which may differ significantly from its past behavior. The market is, of course, fully justified in seeking to make this independent appraisal of the future, and for that reason any automatic rejection of the market’s verdict because it differs from a formula valuation would be the height of folly. We cannot avoid the observation, however, that the independent appraisals made in the stock market are themselves far from infallible, as is shown in part by the rapid changes to which they are subject. It is possible, in fact, that they may be on the whole a no more dependable guide to what the future will produce than the values reached by our mechanical processing of past data, with all the latter’s obvious shortcomings.

Let us turn now to our second mathematical approach, which concerns itself with future growth, or future earnings, as they appear to be predicted by the market price itself. We start with the theory that the market price of a representative stock, such as any one in the Dow-Jones group, reflects the earnings to be expected in a future period, times a multiplier which is in turn based on the percentage of future growth. Thus an issue for which more than average growth is expected will have this fact shown to a double degree, or squared, in its market price—first in the higher figure taken for future earnings, and second in the higher multiplier applied to those higher earnings.

We shall measure growth by comparing the expected 1957–66 earnings with the actual figures for 1947–56. Our basic formula says, somewhat arbitrarily, that where no growth is expected the current price will be 8 times both 1947–56 earnings and the expected 1957–66 earnings. If growth G is expected, expressed as the ratio of 1957–66 to 1947–56 earnings, then the price reflects such next decade earnings multiplied by 8 times G.

From these assumptions we obtain the simple formula:

To find G, the expected rate of future growth, we have only to divide the current price by 8 times 1947–56 earnings, and take the square root.

When this is done for the Dow-Jones Average as a whole, using its August 5, 1957, price of 500, we get a value of 1.5 for G—indicating an expected growth of 50% for 1957–66 earnings vs. the 1947–56 actuality. This anticipates an average of $41 in the next decade, as against $27.50 for the previous 10 years and about $36 in 1956. This estimate appears reasonable to the writer in relation to the 500 level. (In fact, he started with this estimate and worked back from it to get the basic multiplier of 8 to be applied to issues with no expected growth.) The price of 500 for the D. J. Average would represent in turn a multiplier of 8 × 1.5, or 12, to be applied to the expected future earnings of $41. (Incidentally, on these assumptions the average current formula value of about 400 for the Dow-Jones Average would reflect expectations of a decade-to-decade growth of 35%, average earnings of $37.1 for 1957–66, and a current multiplier of 10.8 for such future earnings.)

In Table 1.2 we set forth the results of applying this second approach to the 30 Dow-Jones issues. (The figures for Am. Tel. & Tel. might well be ignored, since utility issues should take a different basic formula.) The main interest in the table lies in the disparities it indicates between the expected future growth, implicit in the market prices, and the actual growth during the past decade. Ten of the companies (plus ATT) sold at prices anticipating at least twice the Dow-Jones Average rate of growth, comparing 1957–66 with 1956. Of these only two, Du Pont and General Electric, had actually shown distinctly better than average growth in the last 10 years. Conversely, eight of the companies were indicating less than half the average expected rate of growth, including five for which actual declines from 1956 levels were apparently predicted. Yet of these eight companies, no less than five had actually shown far greater than average growth in the past decade.

TABLE 1.2 Formula Calculations of Expected Growth of Earnings of Dow-Jones Ind. Issues, as Indicated by August 5, 1957 Price

This leads us to our final observations, which tie our two tables together. The 10 companies previously mentioned, for which unusually rapid growth is anticipated, includes seven of those shown in Table 1.1 as selling significantly above their formula valuation. Again, the eight for which subnormal or no growth is expected include six which were selling substantially below their formula valuations.

We conclude that a large part of the discrepancies between carefully calculated formula values and the market prices can be traced to the growth factor, not because the formulas underplay its importance, but rather because the market often has concepts of future earnings changes which cannot be derived from the companies’ past performance. The reasons for the market’s breaking with the past are often abundantly clear. Investors do not believe, for example, that United Aircraft will duplicate its brilliant record of 1947–1956, because they consider that a company with the United States Department of Defense as its chief customer is inherently vulnerable. They have the opposite view with regard to Westinghouse. They feel its relatively mediocre showing in recent years was the result of temporary factors, and that the electric manufacturing industry is inherently so growth-assured that a major supplier such as Westinghouse is bound to prosper in the future.

These cases are clear cut enough, but other divergencies shown in our table are not so easy to understand or to accept. There is a difference between these two verbs. The market may be right in its general feeling about a company’s future, but the price tag it sets on that future may be quite unreasonable in either direction.

It is here that many analysts will find their challenge. They may not be satisfied merely to find out what the market is doing and thinking, and then to explain it to everyone’s satisfaction. They may prefer to exercise an independent judgment—one not controlled by the daily verdict of the marketplace, but ready at times to take definite issue with it. For this kind of activity one or more valuation processes, of the general type we have been illustrating, may serve a useful purpose. They give a concrete and elaborated picture of the past record, which the analyst may use as a point of departure for his individual exploration and discoveries in the field of investment values.

NOTES

1. On this point the philosophically inclined are referred to the recent article of David Durand on Growth Stocks and the Petersburg Paradox, in the September 1957 issue of the Journal of Finance. His conclusion is that the growth-stock problem offers no great hope of a satisfactory solution.

2. Can We Improve Methods of Appraising Growth Stocks? by R. A. Bing, Commercial and Financial Chronicle, Sept. 13, 1956; table on p. 24.

a Reprinted from the Financial Analysts Journal (November 1957):11–15. When this article was originally published, Benjamin Graham was a visiting professor of finance at the University of Southern California, Los Angeles.

CHAPTER 2

SEEKING A MARGIN OF SAFETY AND VALUATION

a

Matthew B. McLennan, CFA

The foremost goal of investing is to avoid the permanent impairment of capital, which we believe can be done primarily by investing in companies that provide a margin of safety. Cash and gold also play unique but significant roles in our portfolios that are designed to preserve real wealth.

Nearly two decades ago, my wife and I visited a Buddhist temple on the west coast of Japan. As we walked into the monastery, we were approached by a monk with a piece of paper in his hand. My Western mind-set assumed that he was handing me a nondisclosure agreement or a release of liability, but instead he was holding a sign, written in Japanese, that said if we were to go into the temple, we had to do so with an open mind.

An open mind is also an essential element in the concept of margin of safety. A margin of safety is more about mind-set than it is about any specific algorithm, model, or set of precise inputs. It is about temperament. In my presentation, I describe the mind-set that we have embraced at First Eagle for defining and applying the concept of a margin of safety to help preserve value over time for our clients.

TWO BASIC INVESTMENT GOALS

The most important element in adopting the right mind-set is to have a clear and sensible goal. But a lot of confusion exists in today’s investment industry about what an investor’s goals should actually be. The popular focus is on relative returns, tracking error, and similar measures, but such a focus obfuscates one simple truth—the first and most important goal of investing is to avoid the permanent impairment of capital. If people give an investment manager their hard-earned savings, the manager should first seek to not erode the real value of those savings. The manager should also want to grow the purchasing power of those savings over time.

THE PRICE OF MONEY IS FAKE

Democracy and deflation are like oil and water. Virtually no popular appetite exists for deflation. The consequence is that policymakers are doing whatever it takes to stabilize the price outlook after the deflationary pulse of the global financial crisis, and the result is that the price of money today is actually fake. What do we mean by the term fake?

Short-term real interest rates are negative and meaningfully so. Fiscal deficits aimed at sustaining or smoothing aggregate demand are creating a burgeoning supply of government bonds. Governments are intervening directly in the long end of the bond market through quantitative easing and long-dated sovereign liquidity facilities. Even bank debt during the crisis was guaranteed. Central banks are adhering to exchange pegs, despite the fact that fundamentals do not warrant the exchange pegs and are thus producing vast amounts of reserve accumulation or the need for complicated bailout facilities to ease the required real adjustments.

In some ways, nature’s currency, gold, is an alternative store of value to the paper currency conundrum because it cannot be printed, it is scarce, and its supply is not subject to a political process. But the challenge investors face is that gold has been symmetrically re-rated upward in value as the quality of man-made money has deteriorated. There is no free lunch.

The primary goal of avoiding permanent impairment of capital is difficult to achieve in the current environment because no risk-free instrument exists to help preserve capital in real terms with low credit or valuation risk. Thus, in a reflexive response, investors have begun to invest heavily in longer-term fixed income for some incremental yield, despite low absolute yields. Return envy has also led them to think about owning real assets that have growth potential. Such thematic thinking has driven many investors to invest in the fully valued emerging markets because they believe it is a sector that offers the real return and growth they seek to compensate them for low yields in their fixed-income holdings. The problem is that this approach may not necessarily be the right way to find a margin of safety and to preserve capital. Both thematic decisions ignore individual security risks and the full valuation of both long-duration fixed income and emerging market equities, both of which require substantial faith to be placed in policymakers, who have recently made mistakes.

THE FUTURE IS UNCERTAIN

At First Eagle, the core of our mind-set is not only a clear goal to preserve capital but also a recognition that it is necessary to have the humility to accept uncertainty, as well as to not place excessive faith in the prescience of policymakers. We do not try to predict the next huge thematic growth trend. Let me illustrate why we internalize this philosophy by using the example of a period in history that shares some parallels with today and in which emerging market bond investing was immensely popular, as it is today, because people had excessive confidence in the global financial architecture. The period I am referring to was, similar to today, preceded by two decades of unprecedented global growth. As a result of this growth, it was a period of changing relativities in terms of the geopolitical backdrop—one superpower was peaking, another was in decline, and a third was on the rise. Inflation was low and stable and was believed to have been conquered. Global monetary orthodoxy reigned. Only a year before the beginning of this period, the stock market had also lost 40 percent of its value in a liquidity-induced panic caused by investment trust companies investing long and borrowing short. These are some interesting parallels.

The period I am describing is 1908–1911. An investor who had been investing for a couple of decades prior to that time would have experienced, before 1908, a fairly stable world in which asset values did not appear to be out of balance. That investor may also have had a very precise sense of how to deploy capital in that world, but clearly that sense would soon be proven wrong.

A further warning that not all was certain after the 1907 market panic occurred when the Titanic, the unsinkable ship, sunk on its 1912 maiden voyage. Man cannot control nature. In 1914, an unfortunate assassination in the Balkans led to a domino-like chain reaction among a complex set of geopolitical alliances that precipitated World War I. Man cannot even guarantee rational behavior. Once the war broke out, the New York Stock Exchange, despite being on the other side of the Atlantic Ocean, closed for more than four months. After the war, between 1918 and 1920, the Spanish flu pandemic wiped out nearly 5 percent of the world’s population. The hyperinflation of the Weimar Republic, which broke the fabric of the German political economy and ultimately led to the rise of Hitler and World War II, materialized in 1921–1922, and was followed by a severe depression. One can only wonder what the economic and market prognosticators were predicting with seeming precision in 1913. The lesson this historical comparison teaches is that the future is intrinsically uncertain. The crystal ball is foggy at best. The first step to becoming a sound investor is being honest with oneself. The experience of one generation may be very different from the experience of the generations that both precede it and follow it.

But acknowledging that the future is murky is a very difficult thing for investors to do. Investors and managers alike tend to want to preserve their sense of ego. The sense of actually being able to predict the future is an ego preservation device. At First Eagle, however, we believe that in order to implement a margin of safety approach, it is fundamental to acknowledge that the future cannot be predicted with certainty. Only then does one demand a margin of safety at all times.

DEALING WITH MACRO RISK

Investors have several ways to attempt to control the macro risk in their portfolios: eschew the wrong systemic framework, hold liquid cash and gold, or hedge with options. Ironically, in modern capital theory, the taught response to an assertion that the future is uncertain is for investors to be fully invested in the market portfolio. But if the goal is to preserve capital in real terms, then investors should be willing to not own certain parts of the market portfolio—for example, those parts where property rights may not be respected, or where the government is the leading shareholder with a primary goal to maximize employment and not cash flow, or where valuations are excessive, or where imprudent management behavior is creating impairment risks.

Being fully invested at all times is also not a precondition for success. Some investors argue that if cash has a low real return, a portfolio should never hold any cash because it creates a drag on performance. Cash can be a residual of our investment approach. Because our goal is absolute—to find great businesses with good prices or good businesses with great prices—if the markets become ebullient, as they were in 1999 and 2007, and we cannot find sufficient opportunities, then we wait. The cash builds in the portfolios. It is not a market-timing call. It is about having the flexibility and patience to commit to an absolute set of standards for underwriting across time. The return on the cash is not only its stated return but also the option to deploy it in times of distress when liquidity is not otherwise available.

We like to commit capital when an absence of market liquidity exists. Consequently, some of our lowest cash levels ever occurred in March 2009. The reason was not because we were calling the market bottom but because, as structural business buyers, we committed capital when a wider margin of safety opened. Having a time-varying level of cash in a portfolio is actually an important part of dealing with uncertainty and enables equanimity in underwriting standards.

We also hold gold in our portfolios. We view the value of gold as being inversely related to systemic confidence and positively related to political efforts to inflate the money supply. The reason for this relationship is that the supply of gold is exogenously determined by nature, not politics. All the gold ever mined remains in existence; the supply is thus not a function of any one year of mining output but rather the cumulative stock of all of the gold ever mined. The supply of gold barely moves by more than 1 percent based on the mining output in any given year. Historically, the relative stability of gold’s supply has meant that gold’s value has varied inversely with confidence in a man-made economic system because the supply of man-made money usually becomes less predictable in economic distress. In the United States during the late 1920s, late 1960s, and late 1990s, when people believed that the economic system was strong, markets boomed, confidence was high, and gold was inexpensive relative to the price of equities and personal incomes. But when the economic system frayed in the 1930s, 1980s, and most recently in 2008–2009, gold re-rated upward substantially versus the price of equities and personal incomes.

Hence, gold is used at First Eagle as a source of ballast in our portfolios and has typically been about 10 percent of the overall portfolio. We believe that if the allocation were 15 percent or higher, it would start to become a directional view on gold, which is a situation we want to avoid, given that we know we cannot predict future systemic confidence with precision and we recognize that gold can suffer a generation of poor returns when, and if, systemic faith is restored. Yet, we also would not typically want it below 5 percent of the overall portfolio because it would not provide material ballast.

Another strategy for coping with macro risk is hedging with options. Hedging a portfolio with options, however, requires paying very close attention to the cost of the potential hedge because it is time-definite. Investors often adopt tail-hedging strategies when implied volatility is high and when asset values are cheap, such as after a major market correction. But if investors use a fundamental approach to value options, we believe it becomes possible to identify periods of time when options are expensive or cheap in fundamental terms. The time to buy tail insurance is when asset values are high and implied volatility is low. Yet, most people seem to do the opposite, which is an example of the rear-vision investing that we believe is going on in the world today. Finally, the purchase of options often involves an assessment of counterparty risk. To the extent that an investor is trying to hedge for a tail event, what matters is what the counterparty risk will be in the tail state of the world rather than in the current state of the world.

OWNING AN ENTERPRISE PRESERVES PURCHASING POWER

To preserve purchasing power, investors need to not only avoid permanent impairment of capital but also to keep pace with the continual growth of human potential. Investing in a business enterprise allows investors to participate in humanity’s capacity to continue improving.

The growth in human potential can be measured by numerous improvements over time: the mechanics of trade over roads, rails, and ports; the faster diffusion of ideas, from the speed of a horse to the speed of microprocessors and routers; the potential for greater energy productivity harnessing solar, wind, and nuclear power versus burning timber, coal, and oil; the increased life expectancy through biotechnology and public health initiatives; and the broadening of property rights.

Preserving purchasing power in real terms is not only about participating in the march of man but also about keeping pace with a monetary stock that is growing steadily. In a world of inflation-targeting orthodoxy, modest deflation is not deemed an acceptable outcome. The central banks of advanced economies are practicing some unconventional monetary therapy to try to sustain a rising monetary stock. For example, the U.S. Federal Reserve is trying to put a floor under U.S. inflation, a policy that is producing commensurately greater inflationary pressures in the emerging markets, which are U.S. dollar reserve currency accumulators. As a result, Brazil, Russia, India, and China (the BRIC) have arguably become the monetary epicenters of the world. The annual growth rate for M2 (the amount of money in circulation) in most of these economies has been averaging more than 15 percent, which eclipses the credit growth rate in the United States during the last decade by nearly threefold.

Owning a business is akin to owning the source of productivity. If investors own businesses that generate real cash flow, then that cash flow over time will also scale with the level of nominal activity and capital may be preserved. The result is that investors will come full circle to the first goal of investing: preserving capital, albeit paradoxically through the risky ownership of an enterprise.

SEEK A MARGIN OF SAFETY

The strategic need to be an owner of an enterprise while fundamentally accepting that the world is an uncertain place means investors must demand a margin of safety on each investment that they make. The best way to create a margin of safety is from the bottom up, by analyzing risk security by security.

Karl Popper, who was a leading figure in the field of scientific methodology, said in his book Objective Knowledge that the main difference between Einstein and an amoeba is that Einstein consciously seeks for error elimination.¹ It sounds trite, but it is a very profound realization. Many investors are simply trying to identify the next great wave of new-era investment, such as BRIC recently or technology in the late 1990s, and they try to catch that particular wave only to get dumped. We believe a better approach to investing is to attempt to make the least number of bad choices at the individual security level. To invest with the mind-set of Einstein is not to try and call the market’s ups and downs but rather to avoid errors.

From a bottom-up standpoint, investors should try to avoid the four following paths to permanent destruction of capital: overpayment for a business, business model substitution risk, vulnerability from the wrong capital structure, and management dilution. A lot of value managers were wrong in 2008 because they had a unidimensional sense of a margin of safety that was centered solely on price. Price is an important component of a margin of safety, but a multifaceted approach that incorporates the business model, capital structure, and management integrity is preferable.

Valuation

Businesses can be parsed into two broad categories: commodity businesses and franchise businesses.

A commodity business does not have a competitive advantage. Its intrinsic value is basically its sustainable earnings power divided by its cost of capital. In growing its capital stock, it does not create value because it is only earning its cost of capital. If its capital stock shrinks, however, it will produce more free cash flow than earnings because it will release surplus capital and not need as much to invest in the future. In the absence of product substitution or management stupidity, the valuation exercise for a commodity business is relatively straightforward; it is essentially about identifying the sustainable earnings power and the nominal cost of capital.

A franchise business has some competitive advantage that enables it to generate very high incremental returns on capital. It is like a royalty on a slice of the global economy. On the one hand, however, its growth requires limited capital and thereby creates substantial value. On the other hand, if it loses relevance and shrinks, no meaningful capital is released and value erodes, and there is no shield against this fade. Valuing a franchise business, therefore, requires the discriminating investor to disentangle the concepts of an objective margin of safety and a subjective margin of safety because, counterintuitively, the range of intrinsic value outcomes is broader for a franchise business than a commodity business. The subjective margin of safety is based on the investor’s view of the franchise relevance and prospects for the future. The objective margin of safety is based on entry price. The value of a franchise business, for those without a biased sense of how the company will evolve in relevance, should conservatively assume no real growth but allow for pricing power to pass through the effects of inflation. The nuance here relative to valuing a commodity business is that for a commodity business, inflation produces lower free cash flow than earnings because the maintenance capital expenditures will exceed historical book depreciation. In fact, the capital stock will have to grow by the amount of the inflation, thereby offsetting all the benefits of that growth. Thus, for a commodity business that is growing, use a nominal discount rate to discount earnings. In the case of a franchise business, however, take the business’s earnings power divided by the real cost of capital to estimate intrinsic value. We use real, not nominal, cost of capital because inflation passes through a franchise’s earnings stream without much capital drag—earnings are basically free cash flow irrespective of the level of inflation. In a normal cost of capital environment, the average commodity business is worth a low double-digit multiple of earnings (in the low teens) and the great franchise business, assuming no real growth, is worth a higher multiple of earnings (in the high teens). Assuming an unleveraged capital structure, this value translates to high single-digit earnings before interest and taxes (EBIT) multiples for commodity businesses and lower- to mid-teens EBIT multiples for franchise businesses.

Because of the wide range of outcomes, franchise investing requires not only an objective margin in price but also a subjective margin of safety in the analysis of franchise fade. We only buy franchise businesses that are priced for fade—that is, trading at a multiple lower than the inverse of their real cost of capital—and we try, while acknowledging the limits of our crystal ball, to focus on those that have the potential to endure or grow in relevance.

In simple terms, whether buying a commodity business at a discount to intrinsic value or a franchise priced for fade, typically we are buying businesses at single-digit multiples of EBIT. Investing in equities that are priced for fade creates an error-tolerant system. If a business does not produce the expected results, a margin of safety exists in the price. Taking the concept one step further, if investors have already selected from the lower part of the equity universe that is priced for fade, it is possible to reduce the percentage of companies that will actually fade by focusing on the subjective margin of safety. The objective price is balanced against the subjective fade. Unfortunately, fade cannot be completely eliminated.

The ironclad rule of the universe—entropy—makes it self-evident that nothing will replicate itself into perpetuity and that all forms of order are local and transient. The same line of thinking exists in evolutionary theory. The concepts of fade and entropy mean investors need to think carefully about business model erosion.

Business Model Erosion

Investors are taught to think of businesses as perpetuities, and the typical dividend discount model projects 3–4 percent growth into perpetuity. Instead, investors should assume that every business is on a path to some form of irrelevance. The only unknown is how long the current earnings power can be sustained or increased in a transient fashion. Rather than assume perpetuity, investors should ponder the intrinsic duration of an earnings power stream.

For a commodity business, the basis of earnings power duration is asset life, asset replacement value, and the cost-curve positioning of the business relative to competitors. The earnings power in a commodity business is shielded by the replacement value of its long-lived assets. For a franchise business, the basis of earnings power duration is a specific and sustainable competitive advantage. The focus of our analysis is on identifying local scale advantages and the degree of customer captivity.

So, investors should begin their investment selection process within the universe of equities that are priced for fade and then identify the subset of businesses they want to invest in that are less likely to experience fade. If the business is commodity-like in nature, it must have long-life asset value protection. If the business is franchise-like in nature, it must have intangible asset protection through the strength of its local market position and customer captivity.

Focus on Assets, Not on Residual Equity

Another area to consider, in keeping with the concept of a margin of safety, is seeking a material discount to the intrinsic value of a company’s assets. Equity should be viewed as a residual claim on a business. Equity has value only after debtholders, pension claimants, contingent litigants, and minority interests are satisfied. At First Eagle, we prefer to buy assets at 70 cents on the dollar based on capitalizing EBIT, not post-tax earnings. On the basis of that asset value, we decide what price we are willing to pay for the equity, taking into account the company’s capital structure and other sources of contingent leakage.

A good example of the importance of distinguishing asset value from equity value is how an investor would obtain a margin of safety on a wholesale-funded bank that does not have a lot of non-balance-sheet income. A bank typically has about 10 percent of its assets in equity with the remainder in deposit- and debtholder liabilities. If the bank does not have a retail deposit franchise, then most of the 90 percent nonequity liabilities will be some form of debt issued at market prices. Thus, no matter what investors pay for a wholesale bank’s equity, they are paying at least 90 cents on the dollar for its assets. The equity sliver exists only after the other claimants are paid. It is thus hard to obtain a margin of safety on the assets deemed to be acceptable unless there is some form of below-market deposit funding that creates incremental value or some other source of material intrinsic value based on fee-earning businesses independent of the balance sheet lending activity.

The margin of safety does not have to exist in the price paid for a company’s stock but in the price paid for its assets. For equityholders, the asset value may be there in the long term, but this does not help them if the assets transition to the hands of the senior secured debtholders in a short-term funding crisis. There is no point in owning assets that have some material probability of being taken away. Consequently, investors need to pay a lot of attention to the quality of the capital structure.

Management

The management of an enterprise is also very important. For a typical equity that trades at 10 times gross cash flow (i.e., earnings plus depreciation), the management team will redeploy approximately 10 percent of the face value of an investor’s investment every year. The reality is even more dramatic when mergers and acquisitions (M&A) via new security issuance are included. Over a long holding period, such as more than five years, the management team could easily redeploy 50 percent of the gross cash flow in market capitalization in maintenance capital expenditures, discretionary capital investments, security repurchases, and M&A activities. It is important to thus determine what amount of gross cash flow an investor will receive back as dividends and whether management’s retained capital deployment is accretive or dilutive in nature.

Investors should demand a larger valuation margin of safety in companies with the following management mistakes: (1) implementing poor pricing strategies, such as gouging the customer on price for short-term earnings power or engaging in destructive pricing wars despite an oligopolistic market structure; (2) engaging in fad-driven business migration, such as diversifying away from an advantaged local position or stretching to engage in globalization or product diversification; (3) showing financial imprudence, such as adding large amounts of leverage or putting balance sheet growth ahead of secular market trends; and (4) practicing myopia, or milking the business.

Perhaps one of the best indicators of management prudence is free cash flow generation. Management teams that are focused on generating free cash flow relative to earnings typically are making conservative accounting choices, growing within the speed limit of their business, and making reasoned business decisions. Seek managers who are prudent owners/entrepreneurs focused on sustaining culture and thoughtfully distributing or retiring capital, and avoid expeditionary management teams that are aggressive, new-era thinkers willing to bet the ranch on dilutive terms to feed their ambition.

FLEXIBILITY TO LOOK DIFFERENT

Combining all elements of the margin of safety is more important than believing you have a crystal ball. The successful turning points in First Eagle’s investment track record have often been acts of omission: being out of Japan in the late 1980s, being largely out of technology in the late 1990s, and being largely out of financials in 2007 and 2008. As I said earlier, we do not have a crystal ball; we simply could not find enough businesses during those times in those market environments that embodied the valuation margin of safety and had the sustainable earnings power, conservative management behavior, and conservative balance sheet evolution that we demand. Our peripheral vision for macro capital preservation was the sum total of a set of prudent micro acts of omission.

Almost by definition, a passive approach to investing (i.e., mimicking an index) leads to overweighting the sectors that experience the bubbles because it is in those sectors that the greatest expectations for complacency exist in the system. Most managers seek a low tracking error against a benchmark. The whole notion of minimizing risk by minimizing tracking error is a logical non sequitur. The goal of avoiding permanent impairment of capital means that sometimes investors need to stay away from sectors that embody the wrong set of expectations, even if they are the biggest sectors of the market. Most investment managers are not structured to flexibly implement such an approach.

At First Eagle, we view the market as if it were a piece of marble. The goal of error minimization in structuring a portfolio is similar to chipping away the unwanted pieces of marble to let the statue emerge from within. We do not own the whole block of marble just for the sake of owning it. The point of a margin of safety approach is not to ask, Do we overweight Japan versus the United States? Do we own one sector versus another? Rather, the point is to find clusters of investments that we believe make sense from a margin of safety perspective and thus help in attaining the goal of preserving capital in real terms.

Three clusters of equity securities are typically found in the portfolios we build at First Eagle. The first cluster is what we call eclectic royalties. These equities are similar to franchise businesses; they dominate a slice of the world economy and may help preserve the purchasing power of our clients’ capital. These companies typically have an initial objective margin of safety in being priced for fade and a longer-term margin of safety in subjective relevance. They have dominance in their product or service market, they have balance sheet strength, and they have cultural duration.

The second cluster is scarce real assets because owning real assets at the right price helps preserve real wealth. In addition to owning gold directly as a potential source of portfolio ballast, we have owned such real assets as timberlands and quarries through listed equities. We bought these assets at a discount to the liquidation value of the reserves across time when their equities were depressed, and thus the equity market was essentially paying us for storage. A timberland with a 50-year harvest life or a quarry with 60 years of reserves will produce cash flows of substantial duration. In times of cyclically depressed prices, the market often underestimates the power of this cash flow duration. Scarce real assets often have local market monopolies and, therefore, real pricing power over the long haul.

The third cluster is composed of businesses that have discounted cash flows typically through an accounting distortion. It can be very beneficial for investors when an accounting convention obscures the true economic value of a business because an investor can obtain a very wide margin of safety. We have been long-term investors in investment and insurance holding companies, which have been fertile territories for these kinds of opportunities. Another area of distortion is when a company is in fade and generating a lot more cash flow than GAAP earnings (because GAAP assumes a company reinvests depreciation to sustain the capital stock) or selling assets at market values well in excess of historic book value.

CONCLUSION

A margin of safety in investing requires an initial goal to avoid permanent impairment of capital, a mind-set that accepts uncertainty, and a multifaceted approach centered on error elimination. The result of requiring a margin of safety in each investment is often a portfolio that looks very different from the underlying market and that may have material ballast in cash and gold. In a world where the price of man-made money is fake, an investor needs to be primarily an owner of an enterprise in order to preserve capital. Trying to predict the future with scientific precision is a losing game, but trying to find securities one at a time across the globe that embody a margin of safety in price can help investors endure the inevitable vicissitudes of the business cycle and geopolitical turbulence. It requires patience. The margin of safety approach is applicable in all markets.