Tag Archives: Margin of Safety

Whither the Economy?

securityanalysis1Over the weekend, I was paging through Graham and Dodd’s Security Analysis (5th edition, authors Cottle, Murray, and Block), and thinking especially about discount rates and the margin of safety concept, particularly in light of recent macroeconomic events. It is not yet clear to me how much attention an investor should yield to macroeconomic changes and predictions. Investors often take solace in Warren Buffett’s seeming ambivalence to most macroeconomic data, recalling his many quips about being wholly uninterested in the federal funds rate policy for the upcoming year. Cottle, Murray, and Block touch on these issues in their ninth chapter, on “Qualitative and Quantitative Factors in Security Analysis and the Margin of Safety Concept.” Having laid out the sources of information that an analyst should use, the authors move to the more difficult question—how should the analyst use them?

The basic quandary is this: the analyst could gather nearly infinite information about a given investment, information which would presumably help her to better judge its value. Any constraints on time and attention seemingly hold the analyst back from giving her best judgment. Yet, such constraints are not undesirable, for not all information is essential for a reasonably full evaluation. The analyst must cultivate discernment and practical wisdom in order to know whether the information she has is essential and enough. As our authors observe, “the analyst must exercise a sense of proportion in deciding how deep to delve” (114).

But the specifics here are likely the most useful. An analyst may not need to assess patent protections, geographical advantages, or labor conditions, which may or may not endure. For a stable company, five year financial statements “will provide, if not a conclusive basis, at least a reasonably sound one for measuring the safety of the senior issues and the attractiveness of the common shares” (114).

The company’s “statistical exhibit” though is not enough. “Exceedingly important” are qualitative factors, which—while difficult to assess—require the analyst to examine the nature of the business, the character of management, and the trend of future earnings (115). Particularly pertinent is the business’ position in its industry, its industry’s relative prospects, litigation risk, potential regulatory changes, and social issues. Management represent the face of the business, and many even consider picking good management more important than picking a business in a promising industry. Yet, our authors warn, “little tangible information is available about management… [and] objective tests of managerial ability are few and rather unscientific” (121). Even more worrisome, “there is a strong tendency in the stock market to value the management factor twice,” for both the fact that earnings growth is so robust, and that this capable management produced it (121). Though qualitative factors may be overemphasized and lead to an undue emphasis on perceptions of quality (think of the “Nifty Fifty” and the slogan “Make sure of the quality and price will take care of itself”), researchers Clugh and Meador have concluded that the predictive process is based primarily on qualitative factors.

Thoughout their discussion here, our authors say little explicitly about macroeconomic concerns, in large part because of their emphasis on the presence of a margin of safety for any true investment. As they observe, “when the price is well below the indicated value of a secondary share, the investor has a margin of safety which can absorb unfavorable future developments and can permit a satisfactory ultimate result even though the company’s future performance may be far from brilliant” (504). Though the margin of safety may not guarantee favorable performance by itself, when coupled with sufficient diversification, the margin of safety concept can produce acceptable returns in a variety of macroeconomic environments.

Since an analyst’s time and attention are limited, Graham, Dodd, and Buffett concentrate their energies almost solely on understanding businesses, and in particular, on those aspects of the business which management can control—namely, costs, marketing, and pricing. This concentration, coupled with the margin of safety concept, should be sufficient to defend the investor from unforeseen changes in the broader economy and render detailed economic analysis less relevant to the analyst’s work.

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Ebay–What’s It Worth?

Ebay, we’ve found, operates an auction business that generates recurring sales on the widest variety of products. Its auction model renders substantial cost savings that retailers do not generally enjoy. Because it is the market-leading auction site, sellers can find the buyer willing to pay the most, and buyers find the largest selection of goods available for sale. At some level, this may all be marginally interesting, but the typical investor is most interested in what this business is worth.  Let’s get to it.

Valuations methods vary. Seth Klarman of The Baupost Group, in his Margin of Safety (Harper Collins, 1991), highlights the three methods of valuation he finds useful: a) going-concern value, which employs net present value (NPV) analysis of a business’ future cash flows, b) liquidation value, which prices the sum total of the business’ assets, as if its parts were sold and the business dissolved, and c) stock market value, which is the price at which a business and its subsidiaries would trade in the stock market (121-122). NPV analysis is best suited for evaluating profitable businesses with a consistently demonstrated earnings power; liquidation value works best for evaluating unprofitable businesses that retain assets of some value; stock market value makes sense when evaluating closed-end funds whose net asset value differs from their market value.

Given Ebay’s earnings power, NPV analysis is the best tool for determining the value of Ebay’s business. In future posts, we will offer a NPV analysis of Ebay’s cash flows.

For today, I thought it would be instructive and informative to quickly observe the portfolio of businesses that Ebay has acquired over the last decade and their acquisition prices. In itself, the price that Ebay paid for these businesses is not particularly useful for our valuation of Ebay as a whole. To tip my own hand a bit, I would argue that Ebay has overpaid for some acquisitions; thankfully though, it got a great deal on others.

Since 1999, Ebay has acquired the following businesses (and I will only list those acquisitions greater than 200 million)

Butterfield and Butterfield (1999) ~ 260 million

Half.com (2000) ~ 350 million

Paypal (2002) ~1.5 billion

Marktplaats (2004) ~ 290 million

Rent.com (2004) ~415 million

Shopping.com (2005) ~ 620 million

Skype (2005) ~2.6 billion

Stubhub (2007) ~ 310 million

BillMeLater (2008)~ 945 million

Other misc. small transactions (minimum cost of 600 million)

TOTAL COST ~ 7.89 billion

MARKET CAP of Ebay (as of 2/6/09) ~17.4 billion

In addition, another important acquisition for Ebay was a 25% stake in Craiglist in 2004 for about 13.5 million. The private market value of Craigslist could range anywhere from 2-5 billion, which would value Ebay’s stake in the range of .5 to 1.25 billion.

Most simply, we see that Ebay has a wealth of assets.  Insofar as we can break out and separately value each of these parts, we should be able to come up with a sharper and better valuation.

Coming up next—Valuation, continued.

Disclosure: I, or persons whose accounts I manage, own shares of Ebay at the time of this writing.