Franchise Style

[Palantir]

I know that when you invest in deep value situations, you tend to look for firms that are trading about 40% below intrinsic value or so, in order to have an appropriate margin of safety.

 

 

However, if you're investing in a growth firm, a franchise with an economic moat that has a strong growth rate and expanding market share, what's the appropriate discount to look for? For example, I'm looking at Red Hat (RHT), and I've estimated the IV to be 60, but it is trading at 50....

[Guest deepValue]

I look for a margin of safety in the business, not the price. The price determines my return, the nature of the business and how it is operated determines my margin of safety. The more arbitrary rules you add to your investment process, the more arbitrary your investments will become.

 

If you think that requiring a definite discount to intrinsic value will help you make better investments, then just think through it on your own and determine what makes sense to you. Ask yourself: Why do you require a 40% discount for "deep value" situations? Why are you willing to pay more for Red Hat? Is Red Hat really a safer investment, or are you just making an excuse to break your normal rule? What kind of a return do you expect to earn on an investment in Red Hat at today's price? Is that return acceptable given the amount of risk you're taking?

 

Again, I don't advocate quantifying your margin of safety; I think it's a little too precise in a world that isn't. But it's not a terrible way to keep yourself from making boneheaded investments. If you think through it yourself, you can come up with a discount that you understand and are confident in.

 

/my two cents

[LC]

I look for a margin of safety in the business, not the price. The price determines my return, the nature of the business and how it is operated determines my margin of safety. The more arbitrary rules you add to your investment process, the more arbitrary your investments will become.

 

Well the two go hand-in-hand, don't they? The Margin of Safety is the magnitude of the difference between the two (Price & What You're Paying For)

[ItsAValueTrap]

1- A simple way of looking at a company would be the PEG ratio.

 

2- Another way of looking at it is guestimating future cash flows across a range of scenarios.

 

e.g.

Company has a X% chance of becoming obsolete and going to 0.

Company has a X% chance of continuing its growth as one might expect.

 

etc.

 

Of course the problem with models is garbage in->garbage out.  The underlying assumptions may be way, way off.

[Guest deepValue]

I look for a margin of safety in the business, not the price. The price determines my return, the nature of the business and how it is operated determines my margin of safety. The more arbitrary rules you add to your investment process, the more arbitrary your investments will become.

 

Well the two go hand-in-hand, don't they? The Margin of Safety is the magnitude of the difference between the two (Price & What You're Paying For)

 

Yes, but what you're paying for can't always be quantified. You might say the normalized earning power of a company with a 90% share of a niche market is worth $100, and the same is true for an E&P company with three wells in the Gulf of Mexico. All else equal, you'd pay more for the niche than the E&P, but it's impossible to lay a hard and fast rule that you can apply to all companies. Businesses can't easily be grouped into "wide moat" and "no moat;" there's a continuum that isn't easily quantified. I know that the original poster understands this because he is willing to pay more for a company with a franchise than one without, but to think that all franchises are worth x% of intrinsic value is a little arbitrary.

[Palantir]

I understand it is arbitrary, but it is difficult to determine investments when you're trying to look years into the future. When you're doing deep value, you can put an estimate on the worth of an investment and something like a 40%+ discount in theory gives you a good chance of a good return.

 

I'm going to ask another n00b question. Say you buy a stock exactly at the intrinsic value estimated by the model, say your model assumptions are something like 8% growth and 10% discount rate into perpetuity. What is your expected return if you buy the stock? I suppose if it is expected to be high even if you buy right at IV, then a small discount for a great firm could be justified...

[oddballstocks]

I understand it is arbitrary, but it is difficult to determine investments when you're trying to look years into the future. When you're doing deep value, you can put an estimate on the worth of an investment and something like a 40%+ discount in theory gives you a good chance of a good return.

 

I'm going to ask another n00b question. Say you buy a stock exactly at the intrinsic value estimated by the model, say your model assumptions are something like 8% growth and 10% discount rate into perpetuity. What is your expected return if you buy the stock? I suppose if it is expected to be high even if you buy right at IV, then a small discount for a great firm could be justified...

 

You have the answer to your question in your post, if the company grows at 8%, you get 8% growth.  Depends on what's growing at 8%, if book value is growing and you buy above book you get less.  If earnings are growing then you'll get your 8% growth.

[Palantir]

^ No...I figured it out....buying at IV ensures that your return is equal to discount rate if your growth assumptions hold. In that case, then a large margin of safety is not really that important I suppose.

[Guest deepValue]

^ No...I figured it out....buying at IV ensures that your return is equal to discount rate if your growth assumptions hold. In that case, then a large margin of safety is not really that important I suppose.

 

You can buy a no-growth company at intrinsic value and still get a positive return. If a company will make $100 each year for eternity and your hurdle rate is 10%, then the company's intrinsic value is $1,000. If you pay $1,000 for the company, you will earn $100 (10%) each year on into infinity. The whole purpose of discounting cash flows is to discover what you need to pay to get your required return. A margin of safety will help ensure that you earn your return.