Understanding an analyst’s assumptions and process in valuing a share is more important than the value

By Craig Martin

"If you were to distill the secret of sound investment into three words", wrote Benjamin Graham in The Intelligent Investor, "we venture the motto, "margin of safety"." In investment terms, a margin of safety is generally accepted to the difference between the market price of a share (price at which it is trading) and its intrinsic value (calculated real, true or fair value).

Knowing the intrinsic value of share when you decide to buy or sell is extremely important, but I would argue that if you did not do the analysis, it is equally important to understand the process.

There are various ways in which an analyst one can attempt to determine what he deems to the intrinsic value. If that were an exact science, then I guess markets would be efficient. However, determining intrinsic value is probably 40% art and 60% science. The art part is that you need to make assumptions and approximations, which are rarely perfect. Determination of the intrinsic value is prone to errors in judgment since it takes into account future earnings prospects of the company which are somewhat subjective.
In theory, the further a share price is below its intrinsic value, the greater the margin of safety against future uncertainty and the greater the stock's resiliency to market downturns.

As this is my last article for Biznews for the year, I have supplied a table of some of the companies I have discussed on Biznews over the past few months that are still trading at discounts to my intrinsic value. This is not my comprehensive list, but rather a revisit of some of the ideas I have shared with Biznews readers. Some shares only at a very slight discount (less than 5%) partly because the share prices have run up (along with the market) since I originally wrote about them.

For very high quality shares, I think that you should only really consider getting in if the discount is at least ten percent. For riskier, smaller companies, you should look for a discount of thirty percent or higher. I do prepare my valuations very conservatively (with many values at discounts to book). Regardless though, the table illustrates that there are not many "deep discount" opportunities around at the moment.

Investing is not only about finding companies trading below intrinsic value. Preference should be given to companies where management has some "skin-in-the-game". So, if I take yesterday's article on ARB Holdings as an example, the management team has a good track record and they have a personal financial stake in the business, to the tune of 68%, with the founder, A.R. Burke holding 51%.

Generally, the more common measures of intrinsic value include free cash-flow calculations, price-to-book and simple relative valuations such as the companies PE versus its peers. However, when conducting my investment research, one of the measures of value that I find useful in identifying latent value, is the price to sales ratio (P/S). Ideally a P/S ratio of less than 0.8 will get the share to make my "look deeper" list. This is what got me to look at shares like Sappi, Telkom, Grindrod and Mondi in the past.

Accountants also talk about "margin of safety: in terms of break-even analysis. This is the amount by which the sales level can fall before a business reaches it breakeven point. This calculation might be challenging (but no impossible) for an analyst as it requires an understanding of the fixed costs and variable costs of the business. However, if you look at the P/S ratio and you understand the gross margins and net operating margins of the business, you soon get a feel for when there is possible value.

When designing a long-term portfolio, you are buying into a business, not simply a share. One of the first questions that you would possibly ask about any unlisted company, if you were considering buying it, would be, "what are your sales?"  I would argue that the same question should be asked when you purchase a listed company.

Fortunately, when evaluating a listed company, you can easily determine what the current price per share is relation to the annual sales. Going back to ARB Holdings, the sales to external customers for 2014 was R2,216,658,993. The company has 235,000,000 shares in issue. The sales figure therefore equates 943.3cps against a current share price of 635c. The P/S ratio is thus 0.67 – meaning that ARB Holdings deserves a "deeper look".

Some companies are on extremely low operating margins and this is partly the reason for their low P/S ratios. However, it is sometimes easier for a company to grow margins from 5% to 6% with stagnant revenue than it is for that company to grow revenue by 20%. However both efforts will have the same effect on the bottom-line. If you can increase revenue, with widening operating margins – then you have a winning recipe. Going back to the ARB example, revenue increase 14% from 2013 to 2014 while operating margins increased from 8,3% to 9,2%.

As a value investor at heart, one of the factors that tend to assist in alleviating downside risk is the dividend yield of a company. Normally companies that have a history of paying regular dividends tend to outperform pure growth companies that reinvest their cash. Generally, companies with reliable dividends are also companies with strong cash flows.  However, I have seen, time and time again, that companies with reliable forward dividend yields tend to have limited downside risk, whilst still creating opportunity for capital growth over the long-term. ARB Holdings ticked this box as well.

However, some factors could change the short-term value on a company. For example, if copper prices continue to fall and ARB finds itself holding a lot of cable, they may need to experience short-term write-downs in stock value.  We saw how intrinsic values of oil producers have changed (to the negative) while oil consumers have changed to the positive, almost overnight. Getting hung up on an analyst valuation of Sasol would be detrimental to your investment strategy, if you didn't understand the assumptions he made to get to that value.

So while I have an intrinsic value of 710c on ARB, it is far more important for an investor to understand what factors were considered and assumptions made, in determining the intrinsic value.