Warren Buffett is considered the most famous proponent of value investing and the most successful student of Benjamin Graham, who is regarded as the father of fundamental securities analysis. Graham was also involved in the development of the Chartered Financial Analyst (CFA) certification, which aims to ensure a consistently high standard in the training of securities analysts.
Intrinsic value
In fundamental analysis, intrinsic value (or fair value) refers to the value of a company as determined by objective valuation criteria.
Calculating intrinsic value is an integral part of assessing the relative attractiveness of companies. Value investors define intrinsic value as the sum of all cash that can be extracted from a company (over the chosen planning horizon). This cash is then discounted to its present value.
Unfortunately, intrinsic value cannot be calculated precisely, as it is not a precise number. It is based on estimates of a company's future cash flows, which can fluctuate over time. Furthermore, the discount rate used can also vary. Therefore, value investors calculate a range of a company's intrinsic value, which allows for some flexibility.
"Margin of safety" concept
The "margin of safety" is the difference between a security's fair value and its current market price.
This concept was described by Benjamin Graham in his book "The Intelligent Investor." "If I had to describe the secret of sound investing in three words, I think it would be 'margin of safety,'" Graham stated.
Every investor has a personal threshold that they perceive as "safety." The further the price of an investment falls below its intrinsic value, the greater the investor's sense of security regarding future unforeseen events.
In practice, it is advisable to factor in a "margin of safety" of at least 40% before purchasing shares. It's important to note that this margin of safety can vary depending on the industry, interest rates, and overall economic environment.
Example
- Intrinsic value of share A = EUR 10
- 40% "margin of safety" = EUR 4
- Maximum purchase price = EUR 6
The margin of safety also serves to mitigate the potential for errors in valuation.
"Franchise value" concept
Warren Buffett refers to companies that hold a leading position in their industry and maintain a strong competitive advantage over the long term as "franchise companies." Their competitive advantage protects the business model from competitors like a moat protects a castle from unwanted intruders.
Franchise companies consistently generate higher returns than comparable companies. They possess pricing power, established customer preferences that allow for higher prices in the market, and a stronger negotiating position with suppliers and vendors.
Indicators of a sustainable competitive advantage:
- High cash reserves
- Lower long-term debt and therefore lower interest expenses
- High net margin of more than 20%
- High operating cash flow
- High growth rate of retained earnings
Author
Günther Kornfellner, CFA, CAIA
Derivate Trader, Bybit EU