Safety First!

The Dow Jones shed 140 and 120 points on Thursday and Friday, I saw several articles published the following Monday proclaiming the market was ripe for “bargain hunters.”

What is a bargain. A company’s intrinsic value is a bit tricky to understand. But essentially, if you make an assumption about how much cash a company is likely to make from now until eternity and discount that to the present, you come up with a number. In theory, that number is the true value of the company.

For instance, let’s look at one of the hottest small-cap stocks in recent memory, TASER Intl., Inc. (TASR:NASDAQ). From 2002-2004, TASER’s cash flow from operations went from negative $0.8 million a year to $30.3 million to the good. And during that time, its stock price rose from $1.13 to $32 a share. Of course, nothing rises forever. And for a brief time in 2004, TASR corrected all the way down to $11.88 a share.

Was it a bargain at $11.88? Everyone sure thought so at the time. But the numbers said something different.

Between 2002-2004, TASR grew at a triple-digit rate -- which is not sustainable for very long. But what if you assumed the stun gun company could grow 10% a year for the next 10 years (dating back to 2004)? And at the end of those 10 years, you
could sell your shares outright for 20 times earnings plus cash on hand. Sound reasonable?

After crunching the numbers (using a 10% discount rate), I determined TASR would be worth $825 million by the end of 2013. With 97 million shares outstanding at the time, its intrinsic value was $8.50 a share. In other words, even after falling from $32 to $11.88, TASR was still overvalued. There was no margin of
safety -- meaning you could not buy the company for less than its intrinsic value.

Not surprisingly, TASR trades for $9.61 today -- 19% less than its low in 2004. And it still isn’t worth that much!

The great investors (think Buffett, Munger, Whitman, Greenblatt, Templeton, etc.) insist on buying good companies for less than they are worth. So if there is no margin of safety, they don’t write a check. Neither should you.