When to Sell a Share A Guide to Maximizing Profits and Protecting Your Portfolio

In this concluding chapter, we will tackle some important points that could shape how you make your investment decisions. In the preceding chapter, we discussed the Discounted Cash Flow (DCF) analysis and its capacity to measure a company’s stock’s intrinsic value. While the DCF process is often considered the most reliable approach available, it can have its shortcomings. Remember that any wrong assumptions used might lead to imperfect calculations of the fair price and stock cost.

1.   The DCF model requires us to make predictions about the future cash flow and business cycles. This can be challenging, even for a fundamental analyst or the top management of a business.
2.   The DCF model is particularly impacted by the Terminal Growth rate. Even minor alterations to this value could have a large effect on the calculated per-share value. Taking the ARBL case as an example, 3.5% was chosen as their terminal growth rate – leading to a share price of Rs.368/-. Bumping it up to 4.0%, however, results in a drastically different outcome of Rs.394/-
3.   Once the DCF model is constructed, it should be modified and adjusted with up-to-date information that is incorporated in quarterly and yearly intervals. All factors that are related to the inputs and assumptions of the model should remain current.
4.   DCF is geared toward long-term investing, with nothing to offer those who plan on only holding securities for a limited duration. This makes it unsuitable for investors with one-year horizons.

The DCF model could be a hindrance, since it is built on limited parameters, leaving you unable to take advantage of unique offerings.

Rather than being restricted to the same, one can try to overcome the drawbacks of the DCF Model by making conservative assumptions. Here are some tips and suggestions for the same: 

1.   Achieving a growth rate of around 20% year on year for Free Cash Flow seems to be the optimal level. Although, in some cases where a company is still developing and belongs to an industry with higher potential, a slightly lower rate of increase might be expected – although nothing beyond 20%.
2.   To create an accurate valuation, it can be beneficial to extend the analysis over a lengthy period of time. At the same time, a long-term approach increases the possibility of errors. For this reason, I usually prefer to use a 10 year two stage DCF analysis.
3.   It is advisable to break the DCF analysis into two parts, as illustrated by the ARBL case study in the preceding chapter. As indicated, I would increase the FCF at a set rate in stage 1, then slow down the rate of growth to a lesser pace in stage 2.
4.   Terminal Growth Rate – As mentioned before, the DCF model is subject to terminal growth. The usual guideline – set it as low as you can. I usually opt for around 4%, and don’t let it surge beyond that.

– Margin of Safety

Despite making conservative assumptions, you can never be 100% sure that things won’t go wrong. To provide protection against that risk, the concept of Margin of Safety should be applied. Benjamin Graham’s well-known work, “The Intelligent Investor”, popularised this strategy, which suggests to buy stocks at a discounted price when compared to their intrinsic value. Following the Margin of Safety doesn’t necessarily guarantee success, but it does provide a buffer for errors in estimations.

I adhere to the Margin of Safety principle when I invest. In the case of Amara Raja Batteries Limited, we estimated its intrinsic value to be Rs.368/- per share. We then looked at this figure with a 10% modelling error in mind – that is, we set the lower intrinsic value estimate at Rs.331/-. To be safe, though, I aim to discount the intrinsic value by at least another 30%, creating a bigger margin of safety for myself and better protecting my investments.

Why should we be ultra-conservative? You may question this approach, yet it is the best way to protect ourselves from dangerous expectations and misfortune. In light of all the basics, if a stock looks attractive when priced at Rs.100, then a lower price of Rs.70 only confirms itself as a great investment! This is precisely what seasoned value investors do.

Going back to the case of ARBL –

1.   The intrinsic value is Rs.368/-
2.   Accounting for modelling errors @10%, the lower intrinsic band value is Rs.331/-
3.   Discounting it further by another 30%, to accommodate for the margin of safety, the intrinsic value would be around Rs.230/-
4.   At 230/- I would be a buyer in this stock with great conviction.

When quality stocks are trading at substantially discounted rates, value investors will swoop in to capitalise on the opportunity. Therefore, investors should act quickly when the margin of safety is in play. As a long-term investor, one should not overlook such attractive offerings.

Bear markets can offer great discounts on good stocks – so make sure to have some cash handy! These are typically times when people are quite pessimistic, so it’s a great opportunity to pick up some quality investments.