To my many loyal readers who have asked where I have been for the last several months, my apologies for the absence. I have been busy with many projects, including the launching of my new business Active Investment Management (AIM) Consulting, LLC. I would love to earn your trust as my client! Next, I have been putting the finishing touches on a recently co-authored book with C. Thomas Howard, my long-time writing partner. You can see us both speak at the forthcoming Behavioral Finance Forum in New York City on 5 April 2019.

With that taken care of, let us turn our attention now to one of the foggiest concepts in all of investing: fair value. Say what?! Everyone understands fair value. No, sadly, they do not. I was recently among a group of financial pros and they repeated some of the fictions that surround the fair value measure and that I have heard repeated year after year, and all over the world. Here is what they mess up.

Fair Value ≠ Target Price

Many in the investment community use fair value and target price as interchangeable concepts (I see you, analysts on CNBC). But they are not the same. Let’s blame the sell-side for introducing the whacky and confusing concept of the “target price.” This figure means the price at which a wise investor is supposed to sell her shares in a business. Naturally, it is better if they transact with the firm who issued the target price that they are trusting to do their thinking for them.

Here is why target price is a flawed investing measure:

• Missing assumptions. What are the assumptions baked into the target price? Specifically, what is assumed about the actual underlying performance of the business? What are the expectations for revenue growth and earnings growth?
• Missing time horizon. Target prices usually have an embedded time horizon assumption of 12 months baked into them. But 12 months is an entirely arbitrary number. We could just as arbitrarily choose 10 months, or 14, it really doesn’t matter. Oh wait, except it does. The time horizon under consideration ought to correspond to something relevant about the operating performance of the business, and certainly to a security’s valuation, but it never does, in practice.
• Margin of safety? Are we as investors supposed to compare the current market price of a security with the target price and assume that the differences in the two figures is the margin of safety? It is entirely unclear, actually. Many people assume that this is the case, but if so then they are committing the very error I discuss in the next section below.

For the record, the fair value of an investment is the price for the security estimated from some sort of valuation process. That valuation process frequently has baked into it many, many assumptions. Some of these educated guesses are: an investment time horizon; revenue growth rates; gross margins; increase in marketing expenses; the success of research and development in increasing future profitability; interest expense over some time horizon; the income tax rate; the weighted average cost of capital; and on and on. But these assumptions are not driving the discussion around target prices.

A fair value estimate may be higher than the price of the security under consideration, but most often it is at, or near, the current market price of the security. In other words, fair value is simply a number to which the market price may be compared to spark further understanding about the security in question. Fair value does not contain the “act now” decision-making bias of a target price. Said differently, a target price is actually a trigger point, whereas as a fair value estimate is created to spark discussions and understanding.

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Fair Value vs. Fully-Valued

Now we arrive at the moment in our program where I must fight back disgust. My disgust is that when valuation is taught it is done very poorly. Specifically, what is screwed up, and consequently leads to tremendous misunderstanding is the actual meaning of margin of safety.

Firstly, margin of safety is entirely arbitrary. Some people prefer a 15% value, while still others a 30% value. I have myself even toyed with the idea of a 2 standard deviations below average price as the “correct” margin of safety. Blah, blah. The margin of safety is really determined by the behavioral preferences of the investment decision-maker. Said similarly, margin of safety is the excess value relative to market price that needs to be in place for me to gain comfort with a purchase.

Next, and crucially, the margin of safety is not, I repeat not, the only value to be gained by owning an investment! This was the error that I heard just last week in my meeting with the investment pros. In the discussion they directly related a discount to fair value of 30% to the expected return on the investment we were discussing. This is NOT what margin of safety means, and nor is it what fair value means.

Before I explain what margin of safety means, let me discuss what I believe is the source of confusion. Hidden underneath this misunderstanding about margin of safety is the idea that once the margin of safety is “gone” and the investment is trading at fair value, that the investment is “fully valued.” Nonsense. This is a similar misunderstanding as “target price” above. Here’s how…

A margin of safety, if measured accurately, can be thought of as the excess returns available to the investor who properly understands the security in question. In other words, if the investor’s calculation of margin of safety is correct it is like free money. This is directly comparable to that most hallowed of things, α.

Frequently, even seasoned investment pros treat the moment of when a security has appreciated from initial market value up to fair value as the <gasp!> target price, and they say that the security is fully valued. It is not. Once the market price of a security appreciates to the estimate of fair value it means that going forward an investor can expect to earn the growth rate that is his embedded assumption in his valuation model. It isn’t as if there is some external valuation god that suddenly puts a halt to all of the price appreciation in a security because market value now equals fair value. No. Definitely no!

If, for example, I have baked into my valuation model earnings per share growth of 17%, what it means at the time of purchase with, say, a margin of safety of 30% is that I can expect to earn 17% per year in price appreciation, and that over my investment time horizon I expect additional α equal to my margin of safety. Note: fair value has a time horizon already baked into it courtesy of my modeling, so, ergo my margin of safety also has a time horizon embedded in it. If it turns out that other investors bid up the value of the shares more quickly, and thus cause my margin of safety to evaporate more quickly, then I earn even greater excess returns than I anticipated. Does this make sense? Thought so.

In conclusion, I hope that you never ever again misunderstand the concept of fair value. Next week I turn my attention to ‘time horizon,’ yet another very misunderstood concept in our profession.

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