Students of Roger Montgomery's (Buffett's) intrinsic valuation method

[robusta]

Can someone explain to me what Margin of Safety is and how it is calculated? As I see some big margin of safeties posted here.

I thought initially that the RR already incorporates safety issues, where smaller/volatile companies should be assigned a higher RR.

Margin of safety is basically any discount to intrinsic value. It is a case of more is better.
You should use a higher RR for smaller/volatile companies but still should demand a large margin of safety. (20% +)
The bottom line is any valuation tecnique is not perfect. IMO opinion Roger's is one of the best.
The margin of safety serves two purposes.
1) If you miscalculate the intrinsic value you have a margin to make sure you don't overpay.
2) It can supercharge your returns. If you are buying a business that is rising in value at a discount to intrinsic value eventually the share price should rise to the value of the business.

 

[ubtheboss]

Can someone explain to me what Margin of Safety is and how it is calculated? As I see some big margin of safeties posted here.

I thought initially that the RR already incorporates safety issues, where smaller/volatile companies should be assigned a higher RR.

I may be wrong but I've always assumed that 'required return' (RR) is just another term for 'margin of safety'. With that in mind I second what robusta said previously.

 

[ubtheboss]

'discount rate' is another term that is interchangeable with 'required return' yeah?

Also I think a 20% RR or margin of safety is way too high (sorry Robusta). If you're a student of RM and use his tables then 9-14% (higher RR for higher risk) is fine in my opinion. You could argue some specs need an even higher RR but then IV calculations are not applicable to companies that don't have positive NPAT really. There is a way to value resource companies based on resource estimates and shares outsanding etc but I don't know what it is.

Got my eyes on MCE this morning. News keeps getting better and better with this one.

MLD is retracing a bit as I thought it might but it is still undervalued (despite any issue over future contract renewals- which are not in doubt, they are just a factor of doing business).

 

[pedalofogus]

Hi guys,

This is my first time posting on this particular thread, and that is mainly due to the fact that I only read Value-able a few weeks ago.

Re the discussion about RR and Margin of Safety. My interpretation of Roger's comments in the book and on his blog is that Required Rate of Return is the 'base level' of ROE that you would accept (ie, return you could receive elsewhere). His use of Margin of Safety appears to solely relate to the % difference between the current Market Value (Share Price) and the Intrinsic Value. Therefore, if a company has an IV of $1 per share, and the current SP is 80cents, then you have a margin of safety of 20cents (or 25%). However, if the SP was $1.30, then you have a margin of safety of negative 30cents (or -23%).

Based on that, i agree with ubtheboss that a RR of 20% is too high (i think Roger's range of 8 to 14% provides coverage for most companies). However, i disagree with ubtheboss on a Margin of Safety of 20% being too high. I personally wouldn't buy anything that is less than 20% undervalued.



Now a question for the readers of this thread. Do you think there is a minimum company size that Roger's methods can be applied to? I have a company that I have been watching that only has a $9m market cap, but i feel it ticks all of Roger's boxes (such as:- no debt, unique service, high ROE, etc). I have run a IV calc on it, and the valuation came in at about 3 times the current SP. But i am just not sure if it is too small for the IV calc to be able to work on it?


Any comments appreciated.
Cheers
Pedalofogus

 

[ubtheboss]

Hi guys,

This is my first time posting on this particular thread, and that is mainly due to the fact that I only read Value-able a few weeks ago.

Re the discussion about RR and Margin of Safety. My interpretation of Roger's comments in the book and on his blog is that Required Rate of Return is the 'base level' of ROE that you would accept (ie, return you could receive elsewhere). His use of Margin of Safety appears to solely relate to the % difference between the current Market Value (Share Price) and the Intrinsic Value. Therefore, if a company has an IV of $1 per share, and the current SP is 80cents, then you have a margin of safety of 20cents (or 25%). However, if the SP was $1.30, then you have a margin of safety of negative 30cents (or -23%).

Based on that, i agree with ubtheboss that a RR of 20% is too high (i think Roger's range of 8 to 14% provides coverage for most companies). However, i disagree with ubtheboss on a Margin of Safety of 20% being too high. I personally wouldn't buy anything that is less than 20% undervalued.



Now a question for the readers of this thread. Do you think there is a minimum company size that Roger's methods can be applied to? I have a company that I have been watching that only has a $9m market cap, but i feel it ticks all of Roger's boxes (such as:- no debt, unique service, high ROE, etc). I have run a IV calc on it, and the valuation came in at about 3 times the current SP. But i am just not sure if it is too small for the IV calc to be able to work on it?


Any comments appreciated.
Cheers
Pedalofogus

Hi Fogus,

I think you're right- I confused RR with margin of safety. RR would be the per annum return you would hope to get (i.e. the increase in the share price) like the interest rate you might get on a savings account. Does that sound right?

As per your question on company size- if it has positive NPAT, ROE, DPS and EPS figures I don't see why you couldn't do a Roger-Dodger on it yeah? The smaller it is though the harder it will be to find forecast figures for things like DPS, EPS to plug into your IV calculations.

 

[drlog]

You should also make sure it has positive cash flow and has a competitive advantage?

Often you find things that tick most of the boxes but not all of them - small market cap shouldnt really be a problem though.

On another note - any ideas as to what is happening with MCE? The announcement today looks good but the share price has fallen? It's probably just Mr Market doing his thing but does anyone else have an idea?

Cheers

 

[kermit345]

From my studies (university) and working in the finance industry:

RR = Required Rate of Return and is in relation to a per annum basis. So say the ASX has averaged 10.50% returns in the past 25 years, your Required Rate of Return might be 12% as you expect to do better than the market with your research and selections.

Margin of Safety (What i like to call 'Buffer') = As people have stated, the percentage difference between your intrinsic value calculation and the current share price.

I've expect an RR of between 10-12% is fair enough (i'm sure people would be reasonably happy making 10-12% on their funds per annum) and that the Buffer is more stock relative rather then providing a basis figure such as 20%. This can prove to be a good guideline, but I think some companies command and deserve a premium, so in some circumstances you might be willing to accept a 5-10% buffer as it may not be very often that the company trades under its IV anyway (i.e. a timely opportunity).

I'm continuing to put more and more companies through my value rating and evaluation spreadsheet. I've put approx 20 companies through at the moment, and the more I put through, the greater precision my rating system exhibits. The two companies that have stood out so far on my ratings system are ACR and NCK. I also did a valuation of Forge, can't remember the exact figures for my IV as i'm at work, but I know it was a reasonable way above the current SP.

PM me if you want to discuss my spreadsheet or thoughts further. Always looking for others input/ideas to help refine my own strategy and bounce ideas.

 

[ubtheboss]

You should also make sure it has positive cash flow and has a competitive advantage?

Often you find things that tick most of the boxes but not all of them - small market cap shouldnt really be a problem though.

On another note - any ideas as to what is happening with MCE? The announcement today looks good but the share price has fallen? It's probably just Mr Market doing his thing but does anyone else have an idea?

Cheers

I agree drlog- positive cash flow and competitive advantage essential for long term success.

Been re-reading sections of Roger's book on cash flow. He mentions a good quick way most investors use to look at cash flow (for others that are interested):

Balance sheet cash flow= change in cash - change in borrowings - change in share capital + div paid

('change' is the difference between one year and the next)

He mentions it is important to do this kind of calculation because even though an annual report might show a profit that could just be tricky-dicky accounting. You want a business where cash flow is greater than profit.

Anyway, on the subject of MCE drlog- I was scratchin my head today too. That was a great shareholder update but the 'heard' was headed for the gate. Just Mr Market in my opinion. I bought more at 5.25

 

[ubtheboss]

From my studies (university) and working in the finance industry:

RR = Required Rate of Return and is in relation to a per annum basis. So say the ASX has averaged 10.50% returns in the past 25 years, your Required Rate of Return might be 12% as you expect to do better than the market with your research and selections.

Margin of Safety (What i like to call 'Buffer') = As people have stated, the percentage difference between your intrinsic value calculation and the current share price.

I've expect an RR of between 10-12% is fair enough (i'm sure people would be reasonably happy making 10-12% on their funds per annum) and that the Buffer is more stock relative rather then providing a basis figure such as 20%. This can prove to be a good guideline, but I think some companies command and deserve a premium, so in some circumstances you might be willing to accept a 5-10% buffer as it may not be very often that the company trades under its IV anyway (i.e. a timely opportunity).

I'm continuing to put more and more companies through my value rating and evaluation spreadsheet. I've put approx 20 companies through at the moment, and the more I put through, the greater precision my rating system exhibits. The two companies that have stood out so far on my ratings system are ACR and NCK. I also did a valuation of Forge, can't remember the exact figures for my IV as i'm at work, but I know it was a reasonable way above the current SP.

PM me if you want to discuss my spreadsheet or thoughts further. Always looking for others input/ideas to help refine my own strategy and bounce ideas.

That's about what I though kermit. Thanks for the double check.

So if you're looking at a stock trading at $1 and it's IV is $1.20 then you have a 20% margin of safety. If the return you are looking to get on your money each year is say 12% then- if the company looks good from all the other angles- you would hope it reaches $1.12 in a 12 month period. Since the IV is $1.20 you could feel reasonably safe that your 12% gain is achievable if all goes well. They say that IV and share price will eventually converge so your gain could be higher. There are no guarantees though.

As you suggest kermit you can/ should adjust your RR and margin of safety according to the size and stability of the company.

kermit- if you want to compare IVs feel free to post your inputs and I'll run the numbers to see what my spreadsheet spits out. Same goes for anyone.

Cheers

 

[pedalofogus]

Thanks for the thoughts guys.

You are right ubtheboss, the forecast figures are hard to get hold of, and really all you have to go on is rough figures thrown into agm speeches by directors.

I have also been playing around with TWD this week.I have been coming up with IV's of approx 1.70, which is a fair bit lower than SP of 2.40. But it has been hard to come up with solid figure due to special dividends and demerger of AIR. Would be interested to hear if anyone else has looked into it, because I think it has the possibility to be a special business

 

[pedalofogus]

Hi guys,

This is my first time posting on this particular thread, and that is mainly due to the fact that I only read Value-able a few weeks ago.

Re the discussion about RR and Margin of Safety. My interpretation of Roger's comments in the book and on his blog is that Required Rate of Return is the 'base level' of ROE that you would accept (ie, return you could receive elsewhere). His use of Margin of Safety appears to solely relate to the % difference between the current Market Value (Share Price) and the Intrinsic Value. Therefore, if a company has an IV of $1 per share, and the current SP is 80cents, then you have a margin of safety of 20cents (or 25%). However, if the SP was $1.30, then you have a margin of safety of negative 30cents (or -23%).

Based on that, i agree with ubtheboss that a RR of 20% is too high (i think Roger's range of 8 to 14% provides coverage for most companies). However, i disagree with ubtheboss on a Margin of Safety of 20% being too high. I personally wouldn't buy anything that is less than 20% undervalued.



Now a question for the readers of this thread. Do you think there is a minimum company size that Roger's methods can be applied to? I have a company that I have been watching that only has a $9m market cap, but i feel it ticks all of Roger's boxes (such as:- no debt, unique service, high ROE, etc). I have run a IV calc on it, and the valuation came in at about 3 times the current SP. But i am just not sure if it is too small for the IV calc to be able to work on it?


Any comments appreciated.
Cheers
Pedalofogus

By the way, stock I was referring to in previous post was RZR. Feel free to publicly pick it to pieces, as I would be interested to hear others' thoughts

 

[ubtheboss]

Two of the stocks Roger likes that I've mentioned here - MLD and MCE- are both doing well.

FGE is having a pullback after good earnings upgrade. Looking to buy more at 4.44 or thereabouts.

Another that I asked Roger about and that he likes and rates an A1 or A2- SWL - is also doing quietly well. Thinly traded but gosh it's good.

 

[ScottyfromAussie]

has anyone fixed their RR's?

I fixed mine at 10%, then I just go for a 25%-15% margin of safety

 

[tinhat]

I recently bought Roger's book. I've done IV calculations for all stocks in my portfolio plus those on my watch list.

One company in my portfolio which has a calculated IV I found interesting is RIO. I've used forecast figures for Dec 2010 for eps and dividend and a required ROR of 12% and come to an IV of $450

With BHP, using forecast Jun 2011 results I get an IV of about $100.

Well I sure am looking forward to seeing my money quadruple over the next year or so!

 

[robusta]

A lot of post's on this thread seem to be focused on the valuation technique and forget about the rest of the book that should be factored into the valuation technique.

With very few exceptions high ROE does not last. Other businesses see the massive profits been made and open up in competition often reducing the returns from both businesses.

We need to look for businesses with competitive advantages, price makers not price takers.

We also need to be more conservative with our Intrinsic Values. I hold FGE and MCE, now I believe the value is rising in the next couple of years but some of the IV calculations are ridiculous. These companies can not continue to grow at the rate they have in the recent past, ROE will have to decline and/or the payout ratio will have to increase.

 

[DeCal]

What is the rationale for ROE/RR ^ 1.8 to calculate the book value multiple for eternally reinvested equity? What is the rationale for Simmon's ^2?

No one should except the output until they fully understand the process.

There seems to be logical flaws in the formula so if anyone has the argument for it, that would make for solid discussion.

-Decal

 

[magicmoment]

I recently bought Roger's book. I've done IV calculations for all stocks in my portfolio plus those on my watch list.

One company in my portfolio which has a calculated IV I found interesting is RIO. I've used forecast figures for Dec 2010 for eps and dividend and a required ROR of 12% and come to an IV of $450

With BHP, using forecast Jun 2011 results I get an IV of about $100.

Well I sure am looking forward to seeing my money quadruple over the next year or so!

Hi Tinhat, i think your figures are wrong for BHP and RIO as you ignore the London shares which makes up the other half for BHP and Rio.

Cheers

 

[ubtheboss]

Have any Roger Dodgers been following Acrux (ACR)? Roger had this an A1 on his rating scale but I'm not sure of an IV for ACR. Has anyone crunched the numbers? Has anyone investigated what they do and who their competition is? Vector Vest I noticed has it as a 'buy' with a value somewhere above $5.20. Hmmm....

 

[pedalofogus]

I haven't been watching Acrux, but it is one of the companies on my list of stocks that I intend to perform analysis and IV calculations on over the Xmas break.

I will report back with my thoughts on Acrux (once i have put together some thoughts) haha

 

[Intrinsic Value]

I haven't been watching Acrux, but it is one of the companies on my list of stocks that I intend to perform analysis and IV calculations on over the Xmas break.

I will report back with my thoughts on Acrux (once i have put together some thoughts) haha

There is guy who posted on Rogers blog about this stock as one of his picks for the next year. He didn't post the IV figure but he did have some other encouraging figures. The below figures taken from the blog.

Postive cashflow of $145m,
- Positive company cashflow
- Very high ROE (83%)
- No debt.
- A strong relationship with Eli Lilly who will be marketing the products in the states

I think i remember Roger talking about this one with some reservations i.e. if someone else comes up with a better product in the interim where would you then stand with this company?

It is however a big potential growth area but no without risks of a better product emerging and seriously damaging the brand.