The concept of margin of fafety (MOS) in value investing is
actually very simple: MOS is the difference
of the price of a stock with its intrinsic value. So, let's say a stock has an intrinsic value of Rp1,500, and if you buy it at a price of Rp1,000,
then the discount or here called the
MOS is Rp500. Based on this concept, an investor may be said to have done a right decision on his investment, if he
bought the
stock at a lower price than its intrinsic value, the
lower the better of course. But of course this raises a new question: What is
the intrinsic value? And how is it calculated?
The concept of MOS was first introduced by the investment guru, Benjamin
Graham, and his partner, David Dodd, in 1928 (or 1927), where the main point of
the concept is to determine the intrinsic value which mentioned earlier. Graham’s
most famous protege, Warren Buffett, could be very successful in his investment
career because of his exceptional expertise in determining the intrinsic value
of a stock.
To put it simply, when Buffett can accurately determine that the intrinsic
value of stocks of A, B, and C, are 100, 150, and 200 respectively, while the
price of those stocks on the market were 80, 70, and 250 respectively, then
which stocks to be chosen? Of course, B, because the discount is the large one
(its price was only 70, less than a half of its intrinsic value of 150).
Buffett does not really care if the price of this B stock is quite expensive if
viewed from the number of PER or PBV, as long as the company is really good as
indicated by its high intrinsic value. For this Berkshire Hathaway’ chairman,
it's better to invest in an extraordinary good company which sold at a decent
price, rather than invest in a mediocre company despite its low price. Just
keep in mind, a good stuff certainly cannot be acquired at a very low price,
can it?
Okay, then how is Buffett method in calculating the intrinsic value of a
stock? Prior to that, let us first agree on what is meant by the 'intrinsic
value' here. Based on the various definitions that I have collected from
several different sources, intrinsic value is the true value of a stock, and it
is different from the market value (stock price) or book value (net asset, or
equity of the company). The intrinsic value of an asset including the tangible
(equity) and intangible (prospects, track records, big name of the company,
brand power of products, etc.).
Because these intangible assets are often difficult to be calculated (as
even the financial statement of the company cannot present the exact number of
these assets), then two different investors might have different opinions (or
calculations) related to intrinsic value of the same stock, depending on their
point of view. Yep, intrinsic value is a very subjective measure, and therefore
there is no exact intrinsic value for any stock in the world.
However, if we look at the track record of Warren Buffett that is very very
successful in the stock market armed with his special ability in calculating
intrinsic value, then if there is a formula to calculate intrinsic value, Buffett's formula was the one that we
can use. And here are the following steps of the formula, and trust me, the
steps are much simpler than you think :)
Selecting the Stock
First of all, before calculating the intrinsic value of a stock, we must
first select the stock. Make sure that you choose a company with good financial
performance, and also consistent track record (of the performance) in the long
term, let say in the past 10 or minimum 5 years. The easiest indicators can be seen
from the value of equity and net income, is it large or not, and
keep growing or not. And the easiest example of Indonesian companies that have well
and stable performance in the long run, none other than Unilever Indonesia
(UNVR), Charoen Pokphand Indonesia (CPIN), and Semen Indonesia/previously Semen
Gresik (SMGR).
The consistent financial performance in the past is very important, because
one of elements to calculate the intrinsic value (of Warren Buffett's style) is
to estimate the value of equity and net income (of the company in question) in
the future, where a company with a good track record of performance in the past
would be more likely to record equally good performance in the future. Though
of course there is no guarantee that a company with a good track record will keep
its good performance in the future, as well as a small company with a chaotic
performance in the past could be a great company someday, but still: Companies with good track record of
performance could certainly be more trusted than the bad ones. When a
company need a person for an executive position like manager or director, is it
possible that the company would hire fresh graduates who have not had
experience, or an experienced one but with some issues, say legal issue? You
know the answer.
In addition to a stable performance in the past, you also have to fully understand about the company and
also its business/industry, so in this case you have to learn about the company
as a whole, including their operations, company’s board, company’s properties
and plants, etc. This work of detail is necessary so that you can be pretty
sure that the company will be able to operate in the future without any significant
hindrance, if you find out that the company is a good one, both in finance,
governance, and operations.
Furthermore, according to Buffett, the so-called intrinsic value is the
amount of cash that can be withdrawn from the company as long as it is still in
operation. And the so-called 'cash' is the present value of the company (or
also known as book value), plus the accumulation
of net income that the company would earn in the future, that is, during the
company continues to operate.
For example, if we take Charoen
Pokphand Indonesia (CPIN) to be analyzed, the following is a financial
statement data for the full year of 2012 (we use financial statement for the
full year period, instead of quarterly), of the company.
- The number of shares is 16.4 billion pieces.
- The value of equity is Rp8.2 trillion, so that each share represents equity of Rp499.
- Earnings per share (EPS) for the year 2012 was Rp164.
Okay, if we assume that CPIN will operate for the next 10 years from now,
and that the company would earn EPS of Rp164 per annum, then the accumulation
of EPS for the next ten years is Rp1,640. Then add the current equity value of
Rp499, we will obtain a figure of Rp2,139
per share. Basically, this is the intrinsic value for the stock of CPIN.
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| Logo of PT Charoen Pokphand Indonesia, Tbk |
However, the calculations have not been completed yet. We have mentioned above
that the 'intrinsic value' of Rp2,139 was if we assume that CPIN will operate for
the next 10 years, with an EPS of Rp164 per annum. So there are two questions.
First, are you are pretty sure that CPIN can operate for more than 10 years, let
say 20 years? To make it simple, let’s just answer it: Yes.
Then the second question, whether in the next 20 years, the EPS of the
company will remain Rp164 per annum? Apparently not, because in the last five
years, CPIN had CAGR (compound annual growth rate) of its net income of more
than 50%, so that we can assume that in the next five years, the company would
have the same growth rate. But for conservative approach, let’s make it 20%
only. That means the EPS of CPIN in 2013 will be Rp197, and will be Rp236 in
2014, and so on until in the year 2032 (20 years from now on), the company will
have an EPS of Rp6,287.
Thus, the accumulated amount of the EPS of CPIN for 20 years, ie between
the year of 2013 to 2032, will reach Rp36,740.
Just a note, the EPS for the year 2012 (that is Rp164) is not counted in
the accumulated amount of EPS we’ve talked above, because the EPS, net of
dividends, is already included in the company's equity in the same year (in the
form of retained earnings). Once again, remember that in calculating the
intrinsic value, we have to calculate the accumulated net profit which will be
earned by the company in the future, not the net income that has been earned.
Now, remember that the value of money of Rp1,000 at ten years ago, is
different from Rp1,000 at the present, because of inflation. And in the next
ten years, it is likely that the money of Rp1,000 will have a less value than
it is now. That means, when we say that the accumulated net profit of CPIN was Rp36,740
in 2032, then the figure should be adjusted. How? By divide it with the annual
interest rate offered by the safest investment instrument in the country, in
this case (according to Buffett’s opinion), the interest on bonds issued by the
Government.
In Indonesia, there are several types of such government bonds, such as government
securities (surat utang negara/SUN), retail bonds, and ‘sukuk’ (islamic bonds).
Let's say we take the interest rate of sukuk, which is 6.25% per annum (don’t be surprised of the high figure, as
inflation rate in Indonesia is also very high). So, the money of Rp36,740 in
2032 is equivalent to Rp34,579 in 2031, and equivalent to Rp32,544 in 2030, and
so on, until become Rp10,928 in the end of 2012. Added with the company's recent
equity value, ie Rp499, then the total is Rp11,427.
Then it can be said that the current intrinsic value of CPIN is
approximately 11,427, still much higher than the current stock price, which is
only 4,950. In conclusion, the stock is still undervalue! Because its margin of safety was 130% (11,427 against
4,950). Buffett considered that you can buy any stock if its MOS was at least
25%.
However, the intrinsic value of 11,427 is valid only if we assume that CPIN
is tough enough to continue to operate until
the next 20 years. But if we haven’t such optimistic assumption, instead
that CPIN will only operate for the next 10 years, then the intrinsic value of
the stock is only Rp3,285 per share.
Thus, it can be said that CPIN is already overvalued at this point. Buffett
himself used to use the term of 10 years to calculate the accumulated net
income of a company, not more than that.
Thus, here are some things that can be inferred from the illustrations
above:
1. The intrinsic value (of a good
company) is usually higher than the book value
The basic concept of intrinsic value is, when a company has net equity (book
value) of Rp500 billion in its balance sheet, then it does not mean that its
intrinsic value is equal to exactly Rp500 billion, but shall be more than that.
Why? Because from the said capital, the company of course can make some profits,
let's say Rp100 billion per annum (the return on equity/ROE is 20%). The profit
of Rp100 billion then become the property of shareholders, either in form of
dividends or capital gains, so that the amount of money (or assets) owned by the
shareholders, after a year, will be Rp600 billion (initial capital of Rp500
billion plus net income of Rp100 billion), and so on in the subsequent years
the assets will continue to grow, as long as the company continues to operate.
So when an investor is buying a good company with equity value of Rp500
billion, at a price of Rp500 billion as well (or if the number of outstanding shares
is 1 billion pieces, then it means Rp500 per share), or in other words at the PBV
(price to book value) of exactly 1 time, then he must be lucky. Because the
accumulation of net income that the company will earn in the future, which is
owned by previous shareholders earlier, now became his.
That’s why, in a normal market condition, you may have difficulties to find
a good stock that sold at price that reflects PBV of 1 time. The average PBV on
the Indonesian Stock Exchange itself, when the market is not in bullish or
bearish conditions, is 2.0 - 2.2 times. For example of CPIN above, its PBV on
the share price of 4,950 is 9.1 times (quite overvalue, isn’t it?).
However, please remember to underline the word of good company above. Because some stocks with low PBV, say less than
2 times, it could not because it is undervalue, but because it is a bad company,
with negative net income (loss) and poor track record and management, so you
can not assume that the company will be able to generate significant net income
in the years to come. Otherwise, of the ‘premium stocks’ such as UNVR, CPIN,
and SMGR which above, unless there is a financial crisis or market crash, I
guess we will not be able to buy those stocks at a price that reflects the PBV of
1 times.
2. Take an attention to the debt of
company
As Buffett said, the intrinsic value is value of the initial capital plus accumulated
future earnings of the company (which is then discounted by the rate of
inflation/interest rates of government bonds, to obtain its present value). But
what if the company has debts? Then that means, the company bears the burden of
interest that will reduce the future earnings. However, remember that when a
company took a debt, the goal is to increase the working capital, which in turn
increase the revenue and profit. So if the debt can be managed/utilized
properly, then the amount of the increase in profits will be greater than the
interest expense to be paid.
That's why before we calculate the intrinsic value of a stock, the company
in question should have well managed debts
or liabilities. So then we may assume that the debt will not interfere with the
amount of future income. What is meant by 'well managed' here is: 1. The debt
is in reasonable amount, ie should not be too high compared to its equity, with
DER (debt to equity ratio) of less than 2 times, 2. A reasonable rate of
interest, ie 9 - 16% per annume, the smaller the better, and 3. The company has
sufficient assets to pay the debt in full, and they are willing to.
And in this regard we can not pick stocks that the companies in question
has uncontrolled debts, which never be paid unless by other debts. For example,
the companies of Bakrie Group.
3. Take a look at how long the
company operates
In the above example above of calculation of intrinsic value, it is clear
that two different assumptions, first that the company will operate for next 20
years, and the second that the company will only operate for 10 years, may
resulting two different scores, ie 11,427 and 3,285.
But the question is, are you sure that CPIN is able to operate consistently
for the other 20 years without any hurdles? The answer is probably not. Because
although the company have had a good performance in the last five years, but the
total history of the company is not long enough to make an asumption that it
would stand for the next 20 years. CPIN was established in 1972, so the company
have been operating for the last four decade, and I think it is a relatively short
term if compared with the other big (or bigger) companies in Indonesia.
But now just take a look at Unilever
Indonesia (UNVR). I have not been calculated the intrinsic value of the
stock, but if viewed from the PBV that is reaching 40s, then UNVR is obviously
very, very expensive than CPIN, with the PBV of onlu 9.1 times. But do you know
why UNVR is much more expensive? Yep, you’re right, it's because the company
has a much longer track record than CPIN, ie since 1933 (almost 80 years), and
its profitability ratio (and also the other ratios) is also greater. That is,
if for CPIN the investors are still a little hesitant when it is said that the
company will last up to 20 years from now on, then for UNVR, for the next 20
years, people would still believe that the company will still operate properly.
Therefore, as already mentioned above, the track record of performance of
the company in the long run in the past is very important in measuring the
intrinsic value. Buffett himself would rather invest in a mature company that
are already operating for a long time, rather than the newborn company with
short history. Forbes has issued a list of '100 Companies Worldwide that will
last up to 100 years', and most of the list are companies that have been
operating since sooo long, such as Coca Cola, Prudential, Unilever NV, Walt
Disney, and L'Oreal.
4. Avoid the commodity stocks
In calculating the intrinsic value, the stability of the company's financial
performance in the future is essential. That's why Buffett, though not always,
try to avoid stocks which the profits of the company is depend on the price fluctuations
of commodity. For example, coal companies can obtain large profit in a
particular year when the price of coal goes up, but the next year the profit
could go down when the price fell. It can actually be solved by analyzing the
commodity price movements, whether it will rise or fall in the future, but even Buffett could not do it.
As a result, he preferred to acquire the stocks/companies that its product
prices are always rise steadily over time in line of inflation (or more than
inflation), without any significant fluctuations. Examples? Coca Cola. Try to
check at the supermarket, the price of a can of Coca-Cola, Sprite, and Fanta,
it is continue to rise over time, is not it?
However, in this case I have a slightly different view. The so-called commodities,
such as gold, oil and gas, various types of metal, coal, and crude palm oil
(CPO), the price is indeed fluctuating each year, like the price of coal and
CPO had rise in 2011, but now it is already dropped, and it eventually lead to the
poor performance for companies in both sectors.
But in the very long term, the price of any commodities will continue to
rise due to inflation and the increasing demand along with the increasing
number of the world's (or country’s) population. Meaning? If there are stocks which
fell due to the lower commodity prices, such as stocks of coal and palm oil
that has been mentioned above, then it was actually a buying opportunity,
because at the end, the price of the two commodities will rise again in the
future. And that is why, Lo Hong Kheng said that he was currently interested in
buying stocks of coal and oil palm plantations, rather than the other.
5. Take a conservative approach in
calculating the intrinsic value of a stock, and buy the stock at a maximum
price of 25% below its intrinsic value.
As mentioned above, Buffett only choose stocks of a company that have a
track record of performance of tens, or even hundreds of years. One of Buffett
stocks, ie Coca Cola last, was established in 1888, or exactly 100 years when Buffett
began to accumulated it in 1988. However, in calculating the intrinsic value,
Buffett only looking the accumulation of company’s net income in the next 10
years and not more.
Well, now what if I find a good stock with intrinsic value (after my count)
of 1,000, but its price is 1,500? What should I do? According to Buffett, ‘the
price of a stock is often different from its intrinsic value, and it often
happens in a long time. But in the end, the price will be met (be the same)
with the intrinsic value.'
So if you find out that the intrinsic value of A is 1,000, while the market
price is 1,250, then if we assumed that you have had a good calculation, that
means there is only one possibility: The market, or the stock itself, is in bubble, or simply overvalue. And if that happens , then the best option is to wait
for the 'natural mechanism', where sooner or later the stock market (Jakarta Composite
Index/JCI) will down, and stock prices will fall until it reaches its
reasonable price/intrinsic value, or
even lower than that. And that is when you have to get ready for shopping.
On the other hand, if you find that the intrinsic value of a stock is
2,000, while the market price is only 1,000, so despite the JCI is at its peak,
just buy the stock! Buffett, as well as the other investors value (if in
Indonesia, one prominent name is Lo Kheng Hong), pay only little attention to
the position of stock index, if they are going to buy any stocks. They notice
only the intrinsic value of the stocks they were after it, whether they are overvalue,
fair, or undervalue.
One more thing, along with the growth of the company, then the intrinsic
value will continue to rise, and so does the stock price. So, if you buy any
stocks at a lower price than its intrinsic value, then just sit back to watch
your company grow, and also its stock price.
6. Watch the macroeconomics
From the above example of the intrinsic value calculation, it is mentioned
that when we want to discount the value of stocks in the future in order to
obtain its present value, then we can use the government bond interest rate as
a benchmark, which was 6.25% per annum. However, the rate is not always 6.25%,
but changes every time depending on inflation, etc, where if the inflation rate
increases, then the interest rate will also rise. And if the interest rate
increased, then the intrinsic value will be more discounted, aka the lower, or
in other words: The intrinsic value of any
stocks will be lower when inflation rises.
In normal conditions, the inflation rate is changing all the time, but it
will eventually find its point of balance. For example, in Indonesia, the
average inflation rate since the end of 1998 monetary crisis is 7% per year (or
actually 6%, if ignoring the significant changes in 2008), with current rate of
5.9%. But do you know, what were our inflation rates in 2008 and 1998? Believe
it or not, it had reached and 12.1% in 2008, and 82.4% in 1998! And if you
remember, what happened to the stocks on the Stock Exchange at the time?
Anyway, for the reasons that the inflation rate, and also the other
macroeconomics indicators, will eventually return to its normal positions, then
when the crisis is happening, it is always actually a big opportunity to
acquire as much shares (of particular company or several companies) as you can,
at the great sale.
Summary
Okay, actually other than the sic points above, in my head there was much
more explanations about calculateing the intrinsic value, so this article is
actually not finished yet, because it this is actually the main core of stock
investing as a whole. However, since the article is already long enough, so for
now we take the summary. In conclusion, if we intend to invest in the long-term,
then do not compromise with the poor or ‘the invisible’ stocks, but make sure
that you select the stocks are really have good financial performance. And the criteria
of a good stock is at least three:
- Have a long track record of good performance, at least 5 years back, but the longer the better.
- The company has a debt in a reasonable amount, or not have any debt at all.
- You shall choose stocks that are not dependent on the fluctuations in commodity prices, but also do not shut down the opportunity if there is an interesting/undervalue commodity stock.
Then, about the timing to purchase the stocks, is when the price fell by at
least 25% lower than its intrinsic value (the difference of 25% is then called
the margin of safety), and it usually happens when the market is hit by
correction, either large or small. But even in the bullish market conditions,
there almost always stocks with sold at an undervalue price.
On the other hand, do not forget to pay attention to significant changes in
the macro economy, such as inflation and economic growth. Because if it
happened like 2008, or 1998, it does not matter how good the fundamentals of
your stock, or how low the price, it would still go down, probably to a position
that you never imagined before.
Hufft.. Okay, so this article is officially became the longest article in
this blog. If you want to invite me to give speech on campus about stock
investing, the I will be happy to come, just contact me by email teguh.idx@gmail.com. Especially for students, I
do not charge a fee at all.
Original article was written at 2 July, 2013
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