Margin of Safety

Benjamin Graham, the father of security analysis, introduced margin of safety. In his book, The Intelligent Investor, Benjamin Graham advises investors to use margin of safety in investing. His prodigy and the greatest investor of all time, Warren Buffet, once said:

“We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.”

How do investor apply margin-of-safety? First, investor needs to understand the business he wants to invest where he can comfortably predict future cash flows of the business operation in the long term. Then he calculates the intrinsic value of the business based on conservative prediction of free cash flow using discounted cash flow valuation techniques and compare that to the market value. If the market value is close to the intrinsic value, then he should pass the stock. If the intrinsic value is twice higher than the market value or in other word, the market value is 50% of the intrinsic value, then he still needs to verify the reasons why there is such a big different. Is there anything else that needs to be considered since valuation is not an exact science? Valuing a business is part art, part science. Investor need to analyze and think about the franchise value of the product or services the company offer to its customers/clients as well as the sustainability of the business in the long term, which requires investor to analyze the competitive advantage of the business. There are many variables determining the intrinsic value of a business that many times are not clear. However, one thing is clear, the free cash flow or owner's earning (term coined by Warren Buffett) generated by the business and operating profitability can be analyzed and calculated. Warren Buffett in his annual letter to his company's shareholders, perfectly sums up the intrinsic value implementation:

“The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase-irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.”

Even after investor has carefully and painstakingly calculated the intrinsic value of a business, he can still be wrong in his judgment by a wide margin. Here, margin of safety comes in play since he will never invest unless the market value is approx 50% than his intrinsic value figure. Therefore, by applying margin-of-safety, he can be wrong 50% of the value and still be ok.

Asset is also an important variable in valuing a business. Investor can calculate the Net-Net Value of the company to consider the worst-case scenario possibility of valuing asset of the business. In addition, if a business has very valuable asset not reflected in the balance sheet, this figure could be added to the calculation of intrinsic value of the company. Sometimes, during very depressed bear market, the market value of a great business is very close to its Net-Net Asset Value, which can increase your margin of safety significantly if you buy the stock at this cheap valuation.

Margin of Safety in practice:

Situation A:
Intrinsic Value = $100 million
Market Value = $200 million
Margin of Safety = None, even negative $100 million

Situation B:
Intrinsic Value = $100 million
Market Value = $50 million
Margin of Safety = $50 million, which is 100% of market value or 50% of intrinsic value. Here, the market value has 100% upward potential to get to the intrinsic value. Therefore situation B should be considered for investment.

“If we calculate the value of common stock to be only slightly higher than its price, we’re not interested in buying.” – Warren Buffett

Disclaimer: Anthony Hu, the author, is Founder of UndervaluedSecurities.com and Managing Partner of Cheetah Capital Mgmt, a west coast-based private investment partnership that invests in undervalued securities globally.