Tea with Matthew Seah: Margin of safety.

Matthew shares with us a simple and important concept to invest more safely:

The intrinsic value of a company could be calculated base on our estimations of various aspects of the business, both tangible and intangible. Hence one would require to look at both qualitative and quantitative aspects of the business in order to give a more holistic valuation of a company.

Company valuation can be done using 2 broad types of valuation models:
- absolute valuation; and
- relative valuation.

Absolute valuation is a valuation method that give you an absolute value to compare against the current market price. Absolute valuation method is broadly termed as a discounted “cash flow” method. The different models calculates future cash flows -- dividend (Discounted Dividend Model), free cash flow (Discounted Free Cash Flow Model), operating cash flow (Discounted Operating Cash Flow Model), residual income (Discounted Residual Income Model), etc -- and discount these future values to present value.

Relative valuation is a valuation method that compares certain metrics -- price to earnings ratio (P/E), price to book ratio (P/B), price to sales ratio (PSR), total enterprise value to earnings before interest, tax, depreciation and amortisation (TEV/EBITDA), etc -- against the industry or market average.

Each of these valuation models, including those not mentioned, have their pros and cons. 

Do note that even with complete knowledge of the business, company valuation is still an estimation of what the value of the organisation as other external factors such as macro trends and policy changes in the future is difficult to predict.

So how to overcome this miscalculation?

Introducing Margin of Safety. 

The concept of margin of safety originated from Benjamin Graham and he wrote about it in the very last chapter of The Intelligent Investor (Chapter 20: “Margin of Safety” as the Central Concept of Investment).

Simply put, when market price is below your estimation of the intrinsic value, the difference is the margin of safety. The lower the market price of the stock, the more undervalued it is, and the greater the margin of safety. In essence, the risk of losing money is lower when buying an undervalued company with a large margin of safety.

“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” 
- Seth Klarman

Margin of safety doesn't guarantee a successful investment, but it does provide room for error in an our judgment when calculating the value of a company.

Related post:
3 points to note in investing.

This condo investment has been a drag.

Is cash flow sufficient to service debt?





Reader:
Hello AK, I read many of your interesting articles on your blog on financial matters. 

I would greatly appreciate some advice to manage my finances. 

I turned 55 and am still working. 

I live in a 3 room HDB flat fully paid for. 





I purchased a 2-bedder private condo in the east for investment purpose and renting it out since mid 2015. 

The rental is covering my mortgage loan but the other expenses such as property tax, home/fire insurance and maintenance/sinking fund amount to $7000 (a year). 

I am thinking of letting go this property...

AK:
If you are concerned with investing for income to fund your retirement, it seems that this condo is more a drain than a pump. 

If the home loan is going to be paid up soon, then, less to worry about. 

If the home loan has another 10 years (or more) to go, at 55 years old, I might be worried.





Know your motivations and you will know if something is the right tool for you.

Related post:
Buy a condo or stocks?

Don't have to sell HDB flat and buy 2 condos to improve cash flow. (Have a fully paid HDB flat and make money.)

A friend told me he is seriously considering selling his fully paid 5 room HDB flat in RCR to buy 2 shoebox apartments so that he could stay in one and rent out the other for cash flow. 

Hopefully, property prices would go up and he could benefit from capital gain by selling one.





I told him that he would be moving from being debt free to being indebted. 

There is no guarantee that the monthly rental could cover the mortgage payments (plus the much higher monthly maintenance and property tax of a condo).




He says he just wants to make money but how sure is he that he would make money this way? 

I see a strong speculative flavour in his hope that property prices would go up. 

I told him if he thinks property prices would double in 10 years like it did in the recent past, that is speculation.




1.
I told him that if he wants money in the pocket, just rent out 2 bedrooms in his current flat. 

Free cash flow guaranteed. Easy. 

To that, he said that it is very hard to rent out the spare rooms now. 

Oh, and he thinks renting out a shoebox apartment is going to be easier? Duh.





2.
I also told him that if he didn't want to share his home with strangers, he could think about downsizing his current flat to a 3 room flat and he would have more money in the pocket. 

Since his current flat is his first, he could get a BTO 3 room flat. 

It is much cheaper than buying resale.

Or maybe a BTO 2 room flat? 

Price tag? $90,000 maybe. 

So cheap hor?
Purchasing a 2-Room BTO flat








A BTO 2 room flat? Serious? 

Alamak, he was thinking about buying a shoebox apartment to stay in. 

How big do you think a shoebox apartment is?

Of course, he might have to wait a few years but he would be able to pocket a few hundred thousand dollars in price difference. 

Also, he would be getting a fresh 99 years lease. 




3.
Then, there is also the option of looking into HDB's sale of balance flats which would reduce the waiting time.

With the price difference of his old and new flats, he could invest for income and it could even be in the form of a shoebox apartment that he is thinking about once he has served his MOP.

There is no need to always take on more risk in life to have a better life. 





I like to have my cake and eat it too but I don't like to choke on my cake.

Oh, in case you are wondering, he got the idea to sell his 5 room flat to buy 2 shoebox apartments from someone. 

Guess what that someone does for a living?

So clever! Bad AK! Bad AK!





Related posts:
1. Power to be financially stronger.
2. Retirement funding and HDB flats.

5 minutes and less than a dollar? Perfect.

Have you ever had a craving for some food which you have never liked before? 

OK, I know the ladies who have been pregnant before might have experienced this but what about us guys?

Well, I have never enjoyed porridge much. 

So, being on a low carbohydrate diet, it is one thing I do not miss. 





However, whenever I am feeling unwell, I seem to crave porridge. 

I don't know why it is so.

When I told a friend I have been having porridge recently, he asked what about my low carb diet? 

When I told him I have been preparing porridge without using rice, he was dumbfounded.

His expression was priceless and I thought my porridge recipe might be blog worthy.

.





Heat up some frozen fried chicken, frozen cooked vegetables (carrots, broccoli and cauliflower) in a microwave oven. 800 watts, 3 minutes. 

Then, put them in a blender with some hot water.

Blend and we get this. Porridge.

I added some black pepper for taste and also a spoonful of olive oil so that the meal keeps me full longer.

Sedap!





Time taken to prepare the meal? 

5 minutes or so.

Cost? 

Probably less than a dollar.

Add an egg if you like.

Cost?

Probably still less than a dollar.





What did you say? 

Spend 5 hours preparing the perfect bowl of porridge?

Hey, do you think I am really mental? 

OK, don't answer that.





Related post:
How to recession proof your life?