HOW THINKING ABOUT RISKS CAN ADD VALUE TO A TIME HONORED METHOD FOR COMMON STOCK INVESTING

1. RETHINKING THE MARGIN OF SAFETY
HOW THINKING ABOUT RISKS CAN ADD VALUE TO A TIME HONORED METHOD FOR
COMMON STOCK INVESTING
TABLE OF CONTENTS
Executive Summary ....................................................................................................................................................... 2
Model Assumptions ....................................................................................................................................................... 3
Factor Explanation ......................................................................................................................................................... 4
Factor Explanation (continued) ..................................................................................................................................... 5
RAMS In Action .............................................................................................................................................................. 6
Conclusion ..................................................................................................................................................................... 7

2. EXECUTIVE SUMMARY
"A discount is In his pivotal work "The Intelligent Investor", and his first work with David Dodd,
required because "Security Analysis: The Classic 1934 Edition", Benjamin Graham popularized the idea of
of uncertainty; the margin of safety for finding the appropriate price at which to purchase an investment.
our knowledge of In simple terms, the margin of safety is the discount applied to the intrinsic value of a
the correct security determined by an investor. A discount is required because of uncertainty; our
intrinsic value is knowledge of the correct intrinsic value is only an estimate and is subject to forecasting
only an estimate error. While Graham stresses the importance of having an adequate margin of safety,
there is no universal agreement or magic formula for quantifying what level discount is
and is subject to
required.
forecasting error."
In many instances, a subjective discount is applied, rather than using a quantitative
approach which makes economic sense. Furthermore, there is no one size fits all margin
of safety that should be applied to every stock. Every security carries its own set of
unique risks. For example, applying a 30% margin of safety may be appropriate for a
company which sells non-discretionary consumer items. Shifting industries though to a
pharmaceutical drug manufacturer that depends on leverage and successful product
launches likely requires a larger margin of safety to properly account for the excess
relative risks. The paper here will outline a formula specific to each individual common
stock based upon five factors attributable to some type of risk.
Five Risk Factors:
1. Market Risk Factor
2. Leverage Risk Factor
3. Accounting Quality Risk Factor
4. Cash Flow Risk Factor
5. Growth Sensitivity Factor
The combination of these five factors are used to determine a Risk Adjusted Margin of
Safety (RAMS).
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3. MODEL ASSUMPTIONS
"The margin of  Because the intrinsic value of a stock is not perfectly known investors require a
safety can be margin of safety to purchase the stock. The margin of safety can be estimated from
estimated from measureable market risks, specific business risks and forecasting risk.
measureable
market risks,
specific business
 The five factors used are assumed to be the most important risks to investors.
risks and
forecasting
risk."
 Each risk factor is given an equal weight.
 Dividends offer realized returns from investment and therefore reduce the investors’
required margin of safety.
 A non-dividend paying stock with factors equal to 1 have a purchase price of zero
with RAMS.
 Any stock with factors that sum to greater than 1 indicate that the stock could be sold
short.
"Risk/Return is  Risk/Return is not violated; to earn a higher expected return, stocks with larger risk
not violated; to factors must be sought after and vice-versa.
earn a higher
return, stocks
with larger risk
factors must be
sought after
and vice-
versa."
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4. FACTOR EXPLANATION
Beta:" systemic 1) Market Risk Factor - βs
risk, or the risk
of how much
your stock
where βs is the Beta of the stock with the market.
moves with the
market."
All stock investors share what is known as systemic risk, or the risk of how much your
stock moves with the market. Beta is a scaled measure of correlation where a measure of
1 means the stock moves in perfect harmony with the market. If a stock has a Beta higher
than 1, than it will move larger variation relative to the market and vice-versa.
"leverage could 2) Leverage Risk Factor - D/E
expose a
solvency crisis
leaving equity
where D/E is the Debt to Equity ratio.
owners exposed
to steep losses."
The presence of large leverage is a risk factor to equity share holders. Creditors hold a
senior position relative to equity holders in the capital structure. Should an economic
crisis emerge, technology change, demand shift, etc., high levels of leverage could
expose a solvency crisis leaving equity owners exposed to steep losses. The D/E ratio
must be adjusted for off-balance sheet items like significant operating leases and special
purpose entities.
"Use of 3) Accounting Quality Risk Factor - μ (n yr) Accrual Ratio (AR)
aggressive
accruals can be
a signal that
where the Accrual Ratio is ΔNOA/μNOA, where NOA is Net Operating Assets.
earnings are
The Δ (change) in AR is over one year and the μ (average) is from beginning to
unsustainable"
end of the period. The AQR used takes an average of the AR over the past n
years.
Use of aggressive accruals can be a signal that earnings are unsustainable if the cash flow
backing them never materializes. Because accruals from year to year can be volatile, an
average over a period of several years should be used. A persistently high accrual ratio
would be reflected in a high AQR.
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5. "Any business 4) Cash Flow Risk Factor - (σ/μ) CF
with high
variability in its
cash flows can
where (σ/μ) CF is the Coefficient of Variation of Cash Flows over t years.
certainly be
deemed riskier
than the
business that Any business with high variability in its cash flows can certainly be deemed riskier than
has few the business that has few surprises in the dispersion of its cash flows. Dispersion is
surprises in the measured by the σ (standard deviation) and is divided by the μ (mean). The higher the
dispersion of its ratio the more volatility is present in the cash flows of the business.
cash flows."
"the sensitivity 5) Growth Sensitivity Factor - (σ/μ) g
of value to any
particular
growth where (σ/μ) g is Coefficient of Variation of Value from Δ g (growth) estimates.
assumption
can be large."
Thorough analysts will consider a range of scenarios of growth and perform sensitivity
analysis by plugging in different growth assumptions into their forecasts. Often the
sensitivity of value to any particular growth assumption can be large. Dispersion is
measured by the σ (standard deviation) and is divided by the μ (mean). The higher the
ratio the more uncertainty is present in the valuation of the stock.
The five factors are each multiplied by 20% and to find the RAMS subtract the expected
dividend yield from the sum of the five factors:
RAMS = Σ factori – Div1/Ps
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6. RAMS IN ACTION
A real world example is always helpful in creating a better understanding of an theory.
Company: Terra Nitrogen Company, L.P. 1 Symbol: TNH
Intrinsic value estimate2: $116 per share
Calculation of RAMS:
Factor Factor3 Weighted
Type Factor (F*20%)
Beta 0.70 0.14
D/E 0.00 0.00
AQR 0.12 0.02
CFRF 0.99 0.20
GSF 0.36 0.07
Dividend Yield -0.06
RAMS 0.38
The RAMS discount factor is 38%.
RAMS Purchase Price: $72.72 per share [$116 x (1 - .38)]
Decision:
Last Price (as of 6/9/11): $125.93 per share
"A buy decision The last price for TNH is above its intrinsic value estimate per share and far above the
would only be purchase price indicated by using RAMS. Therefore the decision would be to sell shares
reached if the that are currently owned. A buy decision would be reached only if the last price were
last price were equal to or less than the RAMS purchase price.
equal or less
than the RAMS
purchase
price."
1
While writing this white paper the author did own shares in TNH and has since sold his interest.
2
Intrinsic value has been estimated using a free cash flow to equity discount forecast, available upon request.
3
Factor data was obtained through Reuters and from 2010 form 10-k data release by Terra Nitrogen Company, L.P.
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7. CONCLUSION
Matthew Scullen is a RAMS can be a useful tool, especially for value investors who theoretically agree with
candidate in the CFA using a margin of safety, but find it difficult to practically implement due to the
program and has a subjectivity of finding the correct discount to apply.
B.A. in Economics
Using RAMS also does not contradict other models or theories such as CAPM or APT,
from The Ohio State
which are used to determine required returns. Indeed, RAMS can be thought of as a
University. He has
complementary tool to use in the valuation and portfolio management process.
several years
experience working Investors can approach the idea of RAMS flexibly. For instance, APT is not a model
for a financial service because there is no cohesive rule for which factors should be included in the equation,
firm with where CAPM explicitly assumes market risk is the only risk. While in my portrayal I
approximately $50 assume the five factors listed are the only relevant factors to include, I have not labeled
million in AUM. it a model.
If you are interested in contacting Matthew regarding this white paper please feel free
to email him at mscullen1@gmail.com and refer to the white paper in the subject line.
Dated 6/9/2011
Matthew Scullen Page 7