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Margin of Safety

July 23, 2014 | About:

A margin of safety is an investors best friend when trying to find assets that add to a portfolio’s value. In any type of market, a margin of safety can help mitigate risk, allowing an investor the ability to make a sound investment decision, even if they may be wrong in the short term. For value investors, hedging against risk is just as important as having a return on our investment. There are many different ways that we could lose money when investing. We could be wrong in our investment decisions, analysis, or the overall market may decline even though the assets we’ve bought aren’t terrible investments. For these reasons, and many others, the margin of safety allows us to be confident of the decisions we make and ride out the short term storms in order to appreciate the long term paradise.

Guru Focus’ DCF model helps us find the margin of safety in our investments. We can also use the P/B ratio to make sure we aren’t paying too much for the businesses we are interested in. In the DCF model, we are going to swap out EPS for FCF, since it is a better indicator of a companies operational efficiency as well as a way to gauge the company’s ability to pay dividends. For companies that don’t pay dividends, we can use FCF to gauge the amount of money a company can reinvest in its core business. Let’s take a look at Microsoft.

Using Guru’s DCF model and swapping EPS for FCF, we get a a fair value of $52.37, and a margin of safety is 14% without adding the tangible book value. When we do, $60.82 with a margin of safety at 26%. We can look at the outcome and say that, compared to MSFT’s ability to generate cash at the projected growth rate of 13.1% over the next ten years, with a discount rate of 12% and terminal growth rate of 4%, the market is pricing MSFT 14% below its fair value. This could potentially be a buy, but I think we should pair the margin of safety with the P/B ratio of a company to make sure we are truly getting a discount. It is also important to note that one investor’s margin of safety can be completely different than another’s. Margin of safety should only be used as a potential indicator for investing in a stock, not the absolute investment decision.

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Using Guru’s interactive charts, we can view MSFT’s price in relation to its P/B and P/FCF. MSFT is currently trading at 4.1 times its price, and 16 times its free cash flow with a dividend yield of 2.4%. Their free cash flow has been growing, although it did dip a little last year. MSFT seems to be committed to increasing its efficiency, laying off 14% of its workforce and acquiring Nokia. I currently don’t have a position in MSFT, since I usually like to invest in businesses with low P/B ratios, under 3, and low P/FCF, under 15, and a decent dividend. It would be very interesting to see how MSFT does in the months and years to follow. If the margin of safety increases, it could be a very sound investment.

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