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Margin of Safety in Value Investing

 

Warren Buffett calls margin of safety the  “ the three most important words in all of investing, ”   and Benjamin Graham gave rise to the term in  The Intelligent Investor , where he devoted an entire chapter to expanding on its importance as the central concept in any investment operation. The concept of a margin of safety is the supreme foundation of  any business valuation . The margin of safety eliminates catastrophic investment risks. When many investors are first thinking about what gains an investment offers, the investor focused on a margin of safety first thinks about the likelihood of permanent loss an investment offers.
The idea of a margin of safety stems from the reality that no investor, not even Buffett, can determine the exact intrinsic value of any business. Because a company’s intrinsic value is derived from an investor’s calculated set of assumptions, intrinsic value is merely an approximation. Sure, an investor as skilled as Buffett probably would have a  better  approximation of intrinsic value than most, but then again he’s been investing a lot longer than most of us. Nonetheless, his assessment of intrinsic value is still an approximation. When you invest with a margin of safety, you’re investing in such a way that your success is not dependent on exact accuracy future forecasts.
This is why the margin – of – safety concept is of paramount importance to the valuation process. It gives the investor a degree of protection from the market’s uncertainties. There is no formula that determines how wide a margin of safety you need. Obviously the wider the better, and many value investors like a 50 percent margin of safety to feel really comfortable with making an investment. And anything less than 25 percent is not significant. Remember, the point of a margin of safety is to account for the fact that you are making estimates about the future results of the business and any temporary uncertainties in the marketplace. Ultimately, the business will dictate the degree of a margin of safety. A 30 percent margin of safety in WalMart is likely better than a 50 percent margin of safety in the Cheesecake Factory because you can estimate with a higher degree of certainty the future cash flows of a large, stable business that dominates its industry like WalMart versus a  discretionary restaurant like the Cheesecake Factory that competes with thousands of restaurants each day. The margin of safety is like an investor’s insurance policy. The wider the coverage of that policy, the more protection you have. Investing with a margin of safety does not eliminate investment loss. Investing with a margin of safety,  however, does reduce the likelihood of losing significant sums of money in any particular investment.
Investing with a margin of safety of your choice means that your first goal when looking to invest is to focus on return  of  — not  on  — capital. Once you’ve determined a floor price based on a fundamental valuation approach, then investing at or below that floor price ensures that your return of capital is not at a high risk of loss.  The most common type of margin of safety occurs when a company’s tangible assets far exceed its market value. Graham was famous for seeking out net – net values, or securities selling for less than two – thirds of current assets, less all liabilities. That’s the ultimate margin of safety. In a situation like this, if the company were to liquidate, the odds are very good that the equity investors would get their capital back. But as more investors have entered the game, these special situations have become exceedingly more difficult to find.
Many investors have a hard time grasping the concept of a margin of safety because it requires them to truly separate the value of the business from the price of the stock. By way of example, suppose XYZ Corp. was determined to have an intrinsic value of  $ 50 a share and the current stock price was  $ 30 a share, implying a very comfortable 40 percent margin of safety. Suppose over the next month the share price declines 33 percent and now trades at  $ 20 a share.
In many cases, the declining stock price would scare investors away although the margin of safety has just gotten wider. Suppose, however, that the stock price declined to  $ 20 and the intrinsic value declined  $ 10 to  $ 40. Both have declined, but your margin of safety is still very wide. While declining stock prices seem to imply greater risk to many investors, a declining stock price accompanied by a stable intrinsic value  actually gives investors less risk because the margin of safety is higher .
So, the question on many investors’ minds is: How and when will the stock price reach intrinsic value?
The concept of a margin of safety will be more meaningful and understandable after the discussion on intrinsic value, which is the next concept to be covered. Keep in mind that a margin of safety is affected by the intrinsic value of the business. When the intrinsic value changes, so does your margin of safety, and you’ll need to determine whether to keep holding the investment or dispose of it.
Any further attempt at investing intelligently becomes useless and potentially disastrous if you do not incorporate the concept of a margin of safety. Intrinsic values, discounted cash fl  ow assumptions, and other fundamental tools are ineffective if you forget the concept of a margin of safety. Everything you will read in this book centers around this fundamental concept; never forgot it in any single investment consideration.

 Intrinsic Value
To have a satisfactory margin of safety, you first must determine a company’s intrinsic value, because a margin of safety occurs only when a business can be acquired at a significant discount to its intrinsic value. The wider the gap, the stronger the margin of safety. Warren Buffett likes to invest with a 50 percent margin of safety. Mason Hawkins at Long leaf Partners says his group looks for businesses trading at 60 percent or less of intrinsic value. The key focus is to look for opportunities with the widest degrees of margin of safety.  Intrinsic value is a term that is often cited by value investors. It’s a very important concept because all investment decisions should be based on the current market value of the business — the number of shares outstanding multiplied by the current stock price —
relative to the true intrinsic value of the business.
Every business has an intrinsic value. According to John Burr Williams in his 1938 publication  The Theory of Investment Value , intrinsic value is determined by the cash inflows and outflows — discounted at an appropriate interest rate — that can be expected to occur during the remaining life of the business. The reliance on cash flows instead of profits is critical in determining intrinsic value. At the end of the day, it’s all about the cash that the business generates. Cash is real and tangible and cannot be manipulated as profits can. For example, a company can easily increase its sales and hence its profits by extending very generous credit terms to its customers. When you use your Macy’s charge card to make a purchase at Macy’s, the sale has been made and is recorded. But until you pay your bill, the cash has not been received. The profits look good because of the increased sales, but the cash flow shows the real financial picture.
The definition of intrinsic value is painfully simple. Let’s consider an illustration.  Imagine that at the end of this year, your local movie – rental store is up for sale, and the owner is offering it at  $ 500,000 today. Further, let’s assume that the movie store can be sold for  $ 400,000 after 10 years. The store generates free cash fl  ow — money that can be pulled out of the business — of  $ 100,000 a year for the next 10 years.
Meanwhile, you have an alternative low – risk investment opportunity that would yield an annualized 10 percent return on that same  $ 500,000. Tables  6.1  and  6.2  display the results of discounted cash fl  ow analysis of both investment options. Should you buy the movie store, or take the virtually assured 10 percent return? Take a look.
Obviously, the intrinsic value of the  $ 500,000 invested at 10 percent and discounted at 10 percent is exactly  $ 500,000. The movie  store investment provides a better investment opportunity, provided that your annual cash flow and sale price are virtually assured. For the most part, however, cash flows are never guaranteed, and that’s why the intrinsic value figure is only an approximate value, not an exact amount. Yet it does provide the most  accurate  approximation of a business’s true worth. The better your understanding of a business, the better your calculation of intrinsic value will be. And the more data and reasoning you have, the more accurate your intrinsic value becomes.  Comparing the two investment opportunities, you see that the movie store is worth over 50 percent more at the end of the 10 – year period.

Thus, it may seem that there exists a 50 percent margin of safety in making the movie – store investment when compared to the low – risk investment. Such a level of safety is valuable because it protects you, the investor, from uncertainties that may arise over the course of the next 10 years. A new movie store could open up and take away a little (or a lot of business), which would affect the cash flows. In reality, several other factors must be considered before determining that such a wide margin of safety exists in the movie store versus the low-risk investment.
This example was deliberately simplified to illustrate how intrinsic values are calculated and how to determine the margin of safety. The price, or  $ 500,000, is where it all begins. Had the movie store been selling for  $ 700,000, you can see from the numbers that you have very little room for error in your analysis. Also, annual cash flows were kept stagnant, which is not what happens in most businesses. And as you can see, the most significant variable in an intrinsic value analysis is the discount rate applied to the cash flows.

 

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