How to calculate the margin of safety for tech-stocks?
The concept “margin of safety” comes from Ben Graham known as the father of value investing and the mentor of Warren Buffett. After Graham lost almost all of his money during great depression he wrote the book Security Analysis which contains his learned lessons from the stock market crash of 1929. He developed the concept margin of safety for bond investors:
“all experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds….This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income… The margin above charges may be stated in other ways – for example, in the percentage by which revenues or profits may decline before the balance after interest disappears – but the underlying idea remains the same.”
The idea applies to stock investors as follows:
Suppose the Company X has a book value per share of $1.5. The liquidation value per share – in a case of bankruptcy– is $1. If you buy a share of the Company X for 0.8$ you will have $1/$0.8 – 1 =25% as a margin of safety – in a case of liquidation. This means you can buy $1 for a $0.8. If you’re assuming that the Company will not become bankrupt and recover then your margin of safety is $1.5/$0.8 – 1 =88%.
The margin of safety is not a guarantee. Graham has sold all stocks he purchased after max. 3 years regardless he made profit or loss.
In 1930s, the margin of safety explained above can be practiced:
“Ensco International was trading at less than $15 per share, while the replacement value of its rigs was estimated at $35. Patterson-UTI Energy owned some 350 rigs worth about $2.8 billion. Yet its stock was trading for only $1 billion. Investors were getting the assets at a huge discount. Though the subsequent oil price rise made these stocks home runs, the key point is that the investments weren’t dependent on the oil price. Graham and Dodd investors bought into these stocks with a substantial margin of safety.” From the book Security Analysis, p.51.
Warren Buffett has adopted the idea of the margin of safety but he made some changes: firstly, he abolished the time frame of 3 years and changed it to “forever” as long as the Company’s business remains sound. Then secondly, he also changed the way how to determine the margin of safety because after the great depression, finding good companies under book value became more and more difficult.
But the idea remained the same for value investors:
“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” Seth Klarman, founder of the Baupost Group hedge fund.
The key is determining the underlying value. Today, value investors use statistical methods on financial ratios to figure out whether the stock is undervalued or overvalued. For example, if the current price/ earnings ratio PE is under the 5 or 10 years average then probably, the stock would be considered as undervalued. But this kind of methods applies only to the Companies with a successful business and wide economic moat. If a successful company encounters a temporary trouble which could be dealt with or the price declined because of some temporary external effects, like increased interest rates, then the value investors can step in to buy those companies. The intelligent value investors would not buy a stock just because the price has declined.
The method mentioned above requires some stability of financial ratios but the tech-stocks don’t have stable ratios. For example, their earning per share EPS is not only very volatile, it can also be very low or even negative. And the valuation ratios like PE are usually very high and subject to sudden changes.
For example, Tesla TSLA has negative EPS -4.72, and therefore no PE. In this case, you can try to use price to sales ratio PS. In 2013 and 2014, Tesla’s average PS was approximately 10 but in the last two years, it is approximately 6. PS is, relatively speaking, the most stable ratio TSLA has. One can say, some tech giants like Alphabet, Microsoft or Apple are more stable than Tesla but despite their very high market capitalization and huge revenues, nobody should assume that their average ratios from last 5 years will hold in the next 5 years.
Tech companies are operating in a very innovative environment and every time, the market can make drastic changes in their valuation. For example, in 2013, Facebook’s PE has reached to 200 and yet, it is currently 42.
If someone thinks that the tech stocks have no margin of safety and therefore they are a very risky gamble he should remember what Warren Buffett said in an interview with CNBC:
“I was too dumb to realize. I did not think [Jeff Bezos, Amazon’s CEO] could succeed on the scale he has,…. really underestimated the brilliance of the execution… These are powerful, powerful ideas with big potential, and he’s executed” he added that he and partner Charlie Munger “miss a lot of things, and we’ll keep doing it.”
By valuing tech stocks, an investor can not apply the old-school valuation methods but nevertheless, the idea remains the same: find the stocks the market selling under their intrinsic value. The classic valuation methods are very quantitative. They can give an illusion of safety and neglect a lot of important information.
An example, when the street makes estimations about Apple, they heavily focus on iPhone sales and use extrapolation to guess the EPS and revenue of next quartal. And if Apple slightly disappoints them the stock price will be harshly punished. They will argue that the iPhone sales make the majority of the revenue. More dramatic is their fair value estimation which follows the market price. If the price rises they increase the “fair” value and if the price declines they decrease their estimate.But Apple’s ecosystem with more than one billion premium devices and large user base is a safe income resource and the Company’s core business artificial intelligence (AI) will heavily harness the Company’s user base. Apple’s AI will not only enlarge the ecosystem but also generate very high income from it. This is hardly evaluated by street.
The Tech stocks have a margin of safety, but it cannot be determined with mainly quantitative methods. Graham wrote in his book Security Analysis (p. 66):
“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. For such purposes, an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.”
To value a tech-company, an investor has to specialize in the Company’s business. Classic valuation methods which heavily rely on the evaluation of balance sheets, income statements, and financial ratios can be misleading.
How to value a tech-stock:
Usually, the tech-companies with established business have very high-profit margins:
If we look at the Facebook’s gross profit margin which is 86% we can say Facebook should have a very strong monopoly or very wide economic moat. But this is also true for every stock on the table above.
The table above shows the same stocks also have very high Price Book ratio which means the according to Graham’s method, they don’t have any margin of the safety- you can’t buy $1 with $0.60.
Can we apply the valuation methods of Warren Buffett?
The high margins of the tech-companies would be very attractive for investors who follow Buffett’s way of investing because only the companies with wide economic moat can protect their highly profitable business from competition and continue to grow.
For example, today, Facebook has reached 2 billion active users and even Alphabet could not replace Facebook with its G+ despite all support from its search engine, Youtube, and Gmail. Facebook has really a wide economic moat and continues to provide a double-digit increase in revenues.
In case of classic value investment methods, we can calculate the averages of financial ratios and if the stock price declines, i. g. because of Mr. Markets unstable moods, for example, the ratio of EPS falls to 30% below of its 5-year average we can buy the stock with a margin of “safety”.
How reliable would be the 5-year average of a tech-companies financial ratio?
We know G+ could not beat the Facebook but Alphabet’s Youtube can do it when people begin to spend more time on Youtube than on Facebook. Facebook already began to lose it’s users to Instagram because the Instagram is more visual. Video sharing and watching get every day easier and cheaper. And Youtube has already better algorithms (AI) to make video suggestions to users and also monetizing system for content providers. If the users spend less time on Facebook the revenue of the company which comes mainly from Ads would decrease and the EPS and share price will dramatically decline.
Fundamental Analysis of NVIDIA Corp. NVDA:https://t.co/dgJTfFiYvW
— Centhrone (@centhrone_) October 10, 2017
Without getting into more details:
We said Facebook has a high gross profit margin indicating wide economic moat which can be confirmed by 2 billion active users. A replication of Facebook or building a new social media platform with 2 billion users would be very costly and not economical for competition even if the competition can afford it. But Facebook’s problem here is that the competition has not to replicate but innovate which they do.
The financial ratios, ink. gross profit margin, are retrospective and less reliable to predict the future of tech-companies because of fast-changing, innovative business environment. Therefore, Warren Buffett’s valuation methods can be risky or sometimes even misleading.
To value a tech-company, an investor has to figure out the growth potential and then the possibility of its realization. He can use quantitative methods but more likely, the possibility would be intuitively estimated – investing is an art, not a science.
Value = growth potential x possibility
For example, what if Facebook begins to monetize the videos on its platform? Sooner or later, almost certainly, Facebook will do it. In this case, you have to focus on the Facebook’s underlying business and its competition rather than its financial reports. And, in such cases, there would be hardly a general formula to estimate the margin of safety of tech-companies like Buffett’s – Warren Buffett always tried to avoid tech-companies and preferred simple businesses.
Especially, by valuing tech-companies without earnings, cash-burning companies which are usually startups, you have to use the above formula.
to be continued….
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