Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

SEEK A MARGIN OF SAFETY

The strategic need to be an owner of an enterprise while fundamentally accepting that the world is an uncertain place means investors must demand a margin of safety on each investment that they make. The best way to create a margin of safety is from the bottom up, by analyzing risk security by security.

Karl Popper, who was a leading figure in the field of scientific methodology, said in his book Objective Knowledge that “the main difference between Einstein and an amoeba is that Einstein consciously seeks for error elimination.”1 It sounds trite, but it is a very profound realization. Many investors are simply trying to identify the next great wave of new-era investment, such as BRIC recently or technology in the late 1990s, and they try to catch that particular wave only to get dumped. We believe a better approach to investing is to attempt to make the least number of bad choices at the individual security level. To invest with the mind-set of Einstein is not to try and call the market’s “ups and downs” but rather to avoid errors.

From a bottom-up standpoint, investors should try to avoid the four following paths to permanent destruction of capital: overpayment for a business, business model substitution risk, vulnerability from the wrong capital structure, and management dilution. A lot of value managers were wrong in 2008 because they had a unidimensional sense of a margin of safety that was centered solely on price. Price is an important component of ...