Lesson 6 of 7
Klarman: risk, catalysts and cash
Seth Klarman treats value as a range from three techniques, puts the safety in the price, and holds cash as a position when nothing qualifies.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Klarman treats business value as a range, built from three separate techniques.
- When the three disagree, Klarman leans on the lower values unless there is strong reason not to.
- A catalyst can close the gap between price and value on a known timeline. Cash is a position, held when nothing on offer clears the bar.
Klarman's chapter on business valuation opens from a plain admission: value cannot be pinned to a decimal. His method answers that by building a range from three separate techniques and asking whether the price sits comfortably below all of it.
One company, three estimates of value, and the price paid
- Net present value$120
- Stock market value$95
- Liquidation value · the conservative floor$70
Price paid: $60
Value is a range, not a point
A spreadsheet can compute net present value to as many decimal places as you like, but Klarman's point is that the precision is false: the inputs are forecasts, and a forecast is not made more accurate by being carried out further. Reported book value, earnings and cash flow are themselves accounting estimates, not facts read off a ruler.
Three techniques, one range
| Technique | What it asks | Where Klarman leans on it |
|---|---|---|
| Net present value | The discounted value of future cash flow | Stable, high-return businesses and regulated utilities |
| Liquidation value | What the assets bring if the business is sold off, a worst-case floor | An unprofitable business trading well below book value |
| Stock market value | What the company, or its parts, would trade for | The least reliable of the three; a closed-end fund, or a spin-off's likely trading price |
Private-market value, the multiple buyers paid for similar whole businesses, is in Klarman's view a flawed shortcut to the first, net present value. The three techniques do not agree, and their disagreement is itself information about how well the business can be known.
The price is the safety
For Klarman, risk is the chance and size of a loss, and it falls as the price paid falls. A quiet quote is not a safe one. A stock nobody wants and a stock everyone loves can swing by the same amount day to day; what changes is how much cushion the price paid leaves before an error in the estimate turns into an actual loss of capital.
Catalysts, and cash when nothing qualifies
A catalyst, a scheduled liquidation, a breakup, a forced sale, can close the gap between price and estimated value on a timeline the investor does not have to guess at. Where no opportunity clears Klarman's bar, holding cash is itself a position, not a failure to act, and chasing a return by relaxing the bar instead is what he warns against. An investor judged against an index every quarter is pushed toward choices they would not make with their own money over a decade. Klarman treats that pressure to keep pace with a benchmark as something to resist, not a discipline to follow.
Check yourself
Klarman's chapter 8 treats business value as best understood how?
- As a single precise figure from a discounted cash flow model
- As a range, built from more than one technique
- As whatever the stock currently trades for
Show the answer
Answer: B.
Klarman argues precision is false comfort. A range from several techniques is more honest than one point estimate.In the worked example, what is the margin of safety measured against the lowest of the three estimates, $70?
- 50.0 percent
- 14.3 percent
- 0 percent
Show the answer
Answer: B.
(70 − 60) ÷ 70 is 14.3 percent. Even the most conservative estimate still leaves a margin, though a thinner one.In Klarman's method, what is holding cash when nothing qualifies?
- A mistake, since capital should always be invested
- A position in its own right
- A signal to lower the bar until something qualifies
Show the answer
Answer: B.
Klarman treats uninvested cash as a deliberate choice, not an admission of failure, when nothing on offer clears his bar.Sources
- Klarman, Margin of Safety, 1991, chapter 8: the art of business valuation, value as a range.
- Klarman, Margin of Safety, 1991: the price is the safety; holding cash is a position.
What this leaves out
- The three estimates and the price in the worked example are round invented numbers, not any filed company's figures.
- The three valuation techniques can disagree widely on a real company. When they do, Klarman leans on the lower values unless there is strong reason not to.
- Nothing here is advice about any security, and nothing here says when to hold cash.