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2.The second is to compute a market-implied cost of equity for an entire sector and to use this cost as the cost of equity for all companies in that sector. Thus, you could compute the implied cost of equity for all banks of 9 percent, using an index of banking stocks and expected aggregate dividends on that index. You could then use that 9 percent cost of equity for any bank that I had to value. This, in effect, brings discounted cash flow valuation closer to relative valuation; after all, when we compare price-to-book ratios across banks, we are assuming that they all have the same risk (and costs of equity).

3.The third is to compute the market-implied cost of equity for the same company each period across a long period of time and to use that average as the cost of equity when valuing the company now. You are, in effect, assuming that the market prices your stock correctly over time but can be wrong in any given time period and that there are no other fundamental shifts that occurred over time that may have caused your cost of equity to change.

R i s k - A d j u s t e d C a s h F l o w s

All of the alternatives listed in this section are structured around adjusting the discount rate for risk. Consequently, some of you may wonder why we do not risk-adjust the cash flows instead of risk-adjusting the discount rate. The answer to that question, though, depends on what you mean by riskadjusting the cash flows. For the most part, here is what the proponents of this approach seem to mean. They will bring the possibility of bad scenarios (and the outcomes from these scenarios) into the expected cash flows, but that is not risk adjustment. To risk-adjust, you have to take the expected cash flows, replace them with certainty equivalent cash flows, and discount those certainty equivalent cash flows at the risk-free rate.

But what are certainty equivalent cash flows? To illustrate, consider a simple example. Assume that you have an investment, where there are two scenarios: a good scenario, where you make $80 instantly, and a bad one, where you lose $20 instantly. Assume also that the likelihood of each scenario occurring is 50 percent. The expected cash flow on this investment is $30 (0.50 $80 + 0.50 –$20). A risk-neutral investor would be willing to pay $30 for this investment, but a risk-averse investor would not. A riskaverse investor would pay less than $30, with how much less depending on how risk-averse the investor was. The amount he or she would be willing to pay would be the certainty equivalent cash flow.

Applying this concept to more complicated investments is generally difficult because there are essentially a very large number of scenarios and estimating cash flows under each one is difficult to do. Once the expected

cash flow is computed, converting it into a certainty equivalent is just as complicated. There is one practical solution, which is to take the expected cash flow and discount it back at just the risk premium component of your discount rate. Thus, if your expected cash flow in one year is $100 million and your risk-adjusted discount rate is 9 percent (with the risk-free rate of 4 percent), the certainty equivalent for this cash flow would be:

Risk premium component of discount rate = (1.09/1.04) − 1 = 4.81%

Certainty equivalent cash flow in year 1 = $100/1.0481 = $95.41

Value today = Certainty equivalent CF/(1 + Risk-free rate) = $95.41/1.04 = $91.74

Note, though, that you would get exactly the same answer using the risk-adjusted discount rate approach:

Value today = Expected CF/(1 + Risk-adjusted discount rate) = 100/1.09 = $91.74

Put differently, unless you have a creative way of adjusting expected cash flows for risk that does not use risk premiums that you have already computed for your discount rates, there is nothing gained in this exercise.

There are two practical approaches to certainty equivalent cash flows that have been used by some value investors. In the first, you consider only those cash flows from a business that you believe are safe (and you can count on) when you value the company. If you are correct in your assessment of these “safe” cash flows, you have risk adjusted the cash flows. The second variant is an interesting twist on dividends and a throwback to Ben Graham. To the extent that companies are reluctant to cut dividends once they initiate them, it can be argued that the dividends paid by a company reflect its view of how much of its earnings are certain. Thus, a firm that is very uncertain about future earnings may pay only 20 percent of its earnings as dividends whereas one that is more certain will pay 80 percent of its earnings. An investor who buys stocks based on their dividends thus has less need to worry about risk-adjusting those numbers.

The bottom line is that there are no shortcuts in risk adjustment. It is no easier (and it is often more difficult) to adjust expected cash flows for risk than it is to adjust discount rates for risk. If you do use one of the shortcuts—counting only safe cash flows or just dividends—recognize when

these approaches will fail you (as they inevitably will), and protect yourself against those consequences.

M a r g i n o f S a f e t y

Many value investors, suspicious of betas and other measures of risk that emerge from portfolio theory and market prices, argue that there is a far simpler way to incorporate risk into investment analysis, and that is to use a margin of safety (MOS) when assessing whether to invest.

The margin of safety has a long history in value investing. Though the term may have been in use prior to 1934, Graham and Dodd brought it into the value investing vernacular when they used it in the first edition of Security Analysis.13 Put simply, they argued that investors should buy stocks that trade at significant discounts to intrinsic value, and they developed screens that would yield these stocks. In fact, many of Graham’s screens in investment analysis (low PE, stocks that trade at a discount on networking capital) are attempts to put the margin of safety into practice.

In the years since, there have been value investors who have woven the margin of safety into their valuation strategies. In fact, here is how a savvy value investor uses MOS. The first step in the process requires screening for companies that meet good company criteria: solid management, good products, and sustainable competitive advantage; this is often done qualitatively but can be quantifiable. The second step in the process is the estimation of intrinsic value, but value investors use a variety of approaches in this endeavor: some use discounted cash flow, some use relative valuation, and some look at book value. The third step in the process is to compare the price to the intrinsic value, and that is where the MOS comes in: with a margin of safety of 40 percent, you would buy an asset only if its price was more than 40 percent below its intrinsic value. The term returned to center stage in 1991, when Seth Klarman, a value investing legend, wrote a book using the term as the title.14 In the book, Klarman summarizes the margin of safety as “buying assets at a significant discount to underlying business value, and giving preference to tangible assets over intangibles.”

The basic idea behind MOS is an unexceptional one. In fact, would any investor (growth, value, or technical analyst) disagree with the notion

13B. Graham and D. Dodd, Security Analysis (New York: McGraw-Hill, 1934).

14S. A. Klarman, The Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor (New York: HarperCollins, 1991).

that you would like to buy an asset at a significant discount to estimated value? Even the most daring growth investors would buy into the notion, though they may disagree about what to incorporate into intrinsic value. To integrate MOS into the investment process, we need to recognize its place in the process and its limitations.

Stage of the investment process. Note that the MOS is used by investors at the very last stage of the investment process, once you have screened for good companies and estimated intrinsic value. Thinking about MOS while screening for companies or estimating intrinsic value is a distraction, not a help.

MOS is only as good as your estimate of intrinsic value. This should go without saying, but the MOS is heavily dependent on getting good and unbiased estimates of the intrinsic value. Put differently, if you consistently overestimate intrinsic value by 100 percent or greater, having a 40 percent margin for error will not protect you against bad investment choices. That is perhaps the reason why MOS is not really an alternative to the standard risk and return measures used in intrinsic valuation (beta or betas). Beta is not an investment choice tool but an input (and not even the key one) into a discounted cash flow model. In other words, there is no reason why you cannot use beta to estimate intrinsic value and then use MOS to determine whether to buy the investment. If you don’t like beta as your measure of risk, then how does using MOS provide an alternative? You still need to come up with a different way of incorporating risk into your analysis and estimating intrinsic value. Perhaps you would like to use the risk-free rate as your discount rate in discounted cash flow valuation and use MOS as a risk-adjustment measure.

There are those who argue that you don’t need to do discounted cash flow valuation to estimate intrinsic value and that there are alternatives. True, but they come with their own baggage. One alternative is to use relative valuation: assume that the multiple—price- earnings (P/E) ratio or enterprise value/earnings before interest, taxes, depreciation, and amortization (EV/EBITDA)—at which the sector is trading can be used to estimate the intrinsic value for your company. The upside of this approach is that it is simple and does not require an explicit risk adjustment. The downside is that you make implicit assumptions about risk and growth when you use a sector average multiple. The other alternative is to use book value, in stated or modified form, as the intrinsic value. This is not a bad way of doing things, if you trust accountants to get these numbers right—but do you?

A measure of error is needed in your intrinsic value estimate. If you are going to use a MOS, it cannot be a constant. Intuitively, you would expect it to vary across investments and across time. Why? The reason you build in margins for error is because you are uncertain about your own estimates of intrinsic value, but that uncertainty is not the same for all stocks. Thus, you may feel perfectly comfortable using a 20 percent margin of safety when buying stock in a regulated utility where you feel secure about your estimates of cash flows, growth, and risk, whereas you would need a 40 percent margin of safety before buying stock in a small technology company, where you face more uncertainty. In a similar vein, you would have demanded a much larger margin of safety in a banking crisis, when macroeconomic uncertainty is substantial, than in a more settled market environment for the same stock. While this may seem completely subjective, it does not have to be so. If you can bring probabilistic approaches (simulations, scenario analysis) to play in intrinsic valuation, you can estimate not only intrinsic value but also the standard error in the estimates.

There is a cost to having a larger margin of safety. Adding MOS to the investment process adds a constraint, and every constraint creates a cost. What, you may wonder, is the cost of investing only in stocks that have a margin of safety of 40 percent or higher? Borrowing from statistics, there are two types of errors in investing: type 1 errors, where you invest in overvalued stocks thinking that they are cheap, and type 2 errors, where you don’t invest in undervalued stocks because of concerns that they might be overvalued. Adding MOS to the screening process and increasing the MOS reduces your chance of type 1 errors but increases the possibility of type 2 errors. For individual investors or small portfolio managers, the cost of type 2 errors may be small because they have relatively little money to invest and there are so many listed stocks. However, as fund size increases, the costs of type 2 errors will also go up. Many larger mutual fund managers who claim to be value investors cannot find enough stocks that meet their MOS criteria and hold larger and larger amounts in cash.

It gets worse when a MOS is overlaid on top of conservative estimates of intrinsic value. Though the investments that make it through both tests may be wonderful, there may be very few or no investments that meet these criteria. You would love to find a company with growing earnings and no debt that is trading for less than the cash balance on the balance sheet. Who would not? But what are your chances of finding this incredible bargain? And what do you plan to do if you do not find it?

Rather than making intrinsic valuation techniques (such as DCF) the enemy and portraying portfolio theory as the black science, value investors who want to use MOS should consider incorporating useful information from both to refine MOS as an investment technique. After all, all investors have a shared objective. They want to generate better returns on their investments than the proverbial monkey with a dartboard or an S&P 500 index fund.

E Q U I T Y R I S K : A S S E S S I N G T H E F I E L D

Even as we agree to disagree about the usefulness or lack of the same of betas, let us reach consensus on two fundamental facts: to ignore risk in investments is foolhardy, and not all investments are equally risky. Thus, no matter what investment strategy you adopt, you have to develop your own devices for measuring and controlling for risk. In making your choice, consider the following:

Explicit versus implicit. There are plenty of analysts who steer away from discounted cash flow valuation and use relative valuation (multiples and comparable firms) because they are uncomfortable with measuring risk explicitly. However, what they fail to recognize is that they are implicitly making a risk adjustment. How? When you compare P/E ratios across banks and suggest that the bank with the lowest P/E ratio is cheapest, you are implicitly assuming that banks are all equally risky. Similarly, when you tell me to buy a technology firm because it trades at a price-earnings/growth (PEG) ratio lower than the PEG ratio for the technology sector, you are assuming that the firm has the same risk as other companies in the sector. The danger with implicit assumptions is that you can be lulled into a false sense of complacency, even as circumstances change. After all, does it make sense to assume that Citigroup and Wells Fargo, both large money center banks, are equally risky? Or that Adobe and Microsoft, both software firms, have the same risk exposure?

Quantitative versus qualitative. Analysts who use conventional risk and return models are often accused of being too number oriented and not looking enough at qualitative factors. Perhaps, but the true test of a savvy investor is whether you can take the stories that you hear about companies and convert them into numbers for the future. Thus, if your argument is that a company has loyal customers, you would expect to

see the evidence in stable revenues and lots of repeat customers; as a result, the cash flows for the company will be higher and less risky. After all, at the end of the process, your dividends are not paid with qualitative dollars but with quantitative ones.

Simple versus complicated. Sometimes, less is more and you get your best assessments when you keep things simple. In fact, one reason that you may stay with the CAPM is that it is a simple model at its core and you are reluctant to abandon it for more complex models until you are given convincing evidence that these models work better.

Find your own way of adjusting for risk in valuation, but refine it and question it constantly. The best feedback you get will be from your investment mistakes, since they give you indicators of the risks you missed on your original assessment. In addition, remain wedded to the fundamental principle that value is affected by risk but do not be locked into any risk and return model, since it is just a means to an end.

D E F A U L T R I S K

The risk that we have discussed hitherto in this chapter relates to cash flows on investments being different from expected cash flows. There are some investments, however, in which the cash flows are promised when the investment is made and the risk is that these promises will be broken. This is the case, for instance, when you lend to a business by buying a corporate bond. However, the borrower (bond issuer) may default on interest and principal payments on the borrowing. Generally speaking, borrowers with higher default risk should pay higher interest rates on their borrowing than those with lower default risk. This section examines the measurement of default risk and the relationship of default risk to interest rates on borrowing.

In contrast to the general risk and return models for equity, which evaluate the effects of market risk on expected returns, models of default risk measure the consequences of firm-specific default risk on promised returns. Diversification can be used to explain why firm-specific risk will not be priced into expected returns for equities, but the same rationale cannot be applied to securities that have limited upside potential and much greater downside potential from firm-specific events. To see what we mean by limited upside potential, consider investing in bonds issued by a company. The coupons are fixed at the time of the issue, and these coupons represent the promised cash flow on the bond. The best-case scenario for you as an investor is that you receive the promised cash flows; you are not entitled to more than these cash

flows even if the company is wildly successful. All other scenarios contain only bad news, though in varying degrees, with the delivered cash flows being less than the promised cash flows. Consequently, the expected return on a corporate bond should reflect the firm-specific default risk of the firm issuing the bond.

T h e D e t e r m i n a n t s o f D e f a u l t R i s k

The default risk of a firm is a function of two factors. The first factor is the firm’s capacity to generate cash flows from operations, and the second factor is the magnitude of its financial obligations, including interest and principal payments.15 Firms that generate high cash flows relative to their financial obligations should have lower default risk than firms that generate low cash flows relative to their financial obligations. Thus, firms with significant existing investments that generate relatively high cash flows will have lower default risk than firms that do not have such investments.

In addition to the size of a firm’s cash flows, the default risk is also affected by the volatility in these cash flows. The more stability there is in cash flows, the lower the default risk in the firm. Firms that operate in predictable and stable businesses will have lower default risk than will other similar firms that operate in cyclical or volatile businesses. Most assessments of default risk use financial ratios to measure the cash flow coverage (i.e., the magnitude of cash flows relative to obligations) and control for industry effects to evaluate the variability in cash flows.

B o n d R a t i n g s a s M e a s u r e s o f D e f a u l t R i s k

The most widely used measure of a firm’s default risk is its bond rating, which is generally assigned by independent ratings agencies. The two best known are Standard & Poor’s and Moody’s Investors Service. Thousands of companies are rated by these two agencies, and their views carry significant weight with financial markets. The ratings assigned by these agencies are letter ratings. The process of rating a bond usually starts when the issuing company requests a rating from a bond ratings agency. The ratings agency then collects information from both publicly available sources, such

15Financial obligation refers to any payment that the firm has legally obligated itself to make, such as interest and principal payments or lease payments.

It does not include discretionary cash flows, such as dividend payments or new capital expenditures, which can be deferred or delayed without legal consequences, though there may be economic consequences.

as financial statements, and the company itself and makes a decision on the rating. If the company disagrees with the rating, it is given the opportunity to present additional information.

A rating of AAA from Standard & Poor’s and Aaa from Moody’s represents the highest rating granted to firms that are viewed as having the lowest default risk. As the default risk increases, the ratings decrease toward D for firms in default. A rating at or above BBB (Baa) by Standard & Poor’s (Moody’s) is categorized as investment grade, reflecting the view of the ratings agency that there is relatively little default risk in investing in bonds issued by these firms.

The bond ratings assigned by ratings agencies are primarily based on publicly available information, though private information conveyed by the firm to the ratings agency does play a role. The rating assigned to a company’s bonds will depend in large part on financial ratios that measure the capacity of the company to meet debt payments and generate stable and predictable cash flows. A multitude of financial ratios exist, and Table 2.1 summarizes some of the key ratios used to measure default risk.

Not surprisingly, firms that generate income and cash flows significantly higher than debt payments, that are profitable, and that have low debt ratios are more likely to be highly rated than are firms that do not have these characteristics. There will be individual firms whose ratings are not consistent with their financial ratios, however, because the ratings agency does add subjective judgments into the final mix. Thus, a firm that performs poorly on financial ratios but is expected to improve its performance dramatically

T A B L E 2 . 1 Financial Ratios Used to Measure Default Risk

Source: Standard & Poor’s.

over the next period may receive a higher rating than is justified by its current financials. For most firms, however, the financial ratios should provide a reasonable basis for guessing at the bond rating.

W h a t I f a F i r m H a s N o B o n d R a t i n g , a n d W h y D o W e C a r e ?

Not all firms that borrow money have bond ratings available on them. How do you go about estimating the cost of debt for these firms? There are two choices.

One is to look at recent borrowing history. Many firms that are not rated still borrow money from banks and other financial institutions. By looking at the most recent borrowings made by a firm, you can get a sense of the types of default spreads being charged the firm and use these spreads to come up with a cost of debt.

The other method is to estimate a synthetic rating for the firm (i.e., use the financial ratios used by the bond ratings agencies to estimate a rating for the firm). To do this you would need to begin with the rated firms and examine the financial characteristics shared by firms within each ratings class. As an example, assume that you have an unrated firm with operating earnings of $100 million and interest expenses of $20 million. You could use the interest coverage ratio of 5.00 (100/20) to estimate a bond rating of A– for this firm.16

N U M B E R W A T C H

Ratings and default spreads: Take a look at the typical default spreads for bonds in different ratings classes.

The interest rate on a corporate bond should be a function of its default risk, which is measured by its rating. If the rating is a good measure of the default risk, higher-rated bonds should be priced to yield lower interest rates

16This rating was based on a look-up table that was developed in the mid-1990s and has been updated every two years since, by listing out all rated firms with market capitalization lower than $5 billion and their interest coverage ratios, and then sorting firms based on their bond ratings. The ranges were adjusted to eliminate outliers and to prevent overlapping ranges.