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How to Increase Profits and Reduce Risks by Correctly Determining Margin of Safety

July 21, 2014 | About:

Investopedia defines Margin of Safety as: “A principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with minimal downside risk.”

Your valuation of the company may be approximately right. To cushion the downside risks and improve on your upside growth potential, you should buy with a Margin of Safety (buy below your intrinsic value of the company). By correctly determining the appropriate Margin of Safety, you can increase your profits and reduce your risks.

I just finished a great book this Sunday. The follow are some lessons I learned and improved upon:

“Active Value Investing” (AVI) Margin of Safety

Initial Required Rate of Return

In the great value investing book, “Active Value Investing” by Vitaliy Katsenelson, the author defines the Initial Required Rate of Return as follows:

Initial Required Rate of Return = (1 + Dividend Yield) * (1 + Earnings Growth) * (1 + Margin of Safety) – 1

Dividend Yield = Dividend per Share / Share Price

Earnings Growth = (Projected Earnings per Share in n Years / Current Earnings per Share) ^ (1 / n Years) – 1

Earnings Growth is based on projections made for five years or longer. For example, if the Current Earnings per Share = $1.00 and the Projected Earnings per Share in 5 Years = $5.00 then the Earnings Growth is 37.97% or [($5.00/$1.00) ^ (1/5) – 1].

Margin of Safety

If we solve for the Margin of Safety from the Initial Required Rate of Return, we get the following:

Risk Unadjusted Margin of Safety = (1 + Initial Required Rate of Return) / [(1 + Dividend Yield) * (1 + Earnings Growth)] – 1

Risk Adjusted Margin of Safety = Risk Unadjusted Margin of Safety * Business Risk Factor * Financial Risk Factor

You should use your investment judgment for the various risk factors. For example, consider three companies (Outstanding Mart, Average Mart, and Below Mart):

Outstanding Mart

Average Mart

Below Mart

Risk Unadjusted Margin of Safety

15.0%

15.0%

15.0%

*

*

*

Business Risk Factor

0.90

1.00

1.20

*

*

*

Financial Risk Factor

0.95

1.00

1.20

=

=

=

Risk Adjusted Margin of Safety

12.8%

15.0%

21.6%

“True Investment Research” Model

“True Investment Research” (TIR) Model is a modification of the AVI Margin of Safety. The TIR Model adds a factor for country risk (i.e. 1.00 for U.S. stocks and 1.15 for less developed countries). You should use your investment judgment for the various risk factors.

Risk Adjusted Margin of Safety = Risk Unadjusted Margin of * Business Risk Factor * Financial Risk Factor * Country Risk Factor

For example, consider two exactly the same companies located in different countries (Outstanding Mart USA, and Outstanding Mart Russia):

Outstanding Mart USA

Outstanding Mart Russia

Risk Unadjusted Margin of Safety

15.0%

15.0%

*

*

Business Risk Factor

0.90

0.90

*

*

Financial Risk Factor

0.95

0.95

*

*

Country Risk Factor

1.00

1.50

=

=

Risk Adjusted Margin of Safety

12.8%

19.2%

Conclusion

I highly recommend you adding the “Active Value Investing” book to your library. There are a lot of wonderful, well-written ideas and lessons in the book. If you are investing internationally, I recommend you utilize the True Investment Research Margin of Safety approach.

About the author:

Nelson Nguyen
Experienced professional with expertise in financial statement analysis, value investing, and financial modeling. Past employment with the government (Internal Revenue Service), banking, insurance, and accounting service sectors. Licensed CPA with individual and corporate tax compliance experience and a 2015 Level III Candidate in the CFA Program.

Visit Nelson Nguyen's Website


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