This article briefly discusses the relationship between Value Investing and the Margin of Safety; the views of Benjamin Graham as to the Margin of Safety; and a formula for value investors.
Value Investing
In essence, the concept of Value Investing involves buying an asset (stock, bond, real estate, so forth) for a price less than its value (see Figure 1).
So, whenever an individual buys, for instance, a stock for less than its estimated value, he or she is applying this principle.
Margin of Safety
Inherent to value investing is the notion of the "margin of safety." Its importance cannot be over-emphasized. Benjamin Graham (1894-1976), regarded as the father of value investing, coined the term “margin of safety” and considered it to be the Central Concept of Investment (Graham, 1973).
Warren Buffett has stated that: “The Intelligent Investor,” by Benjamin Graham, is by far the best book about investing ever written. He also stressed the importance of chapters 8 (The Investor and Market Fluctuations) and 20 (“Margin of Safety” as the Central Concept of Investment), to avoid poor results from your investments (Graham, 1973). Thus, the greater the margin of safety, the higher the probability of a positive return.
In chapter 20 of “The Intelligent Investor,” Benjamin Graham discusses the margin of safety for two kinds of securities:
1. Bonds and preferred stock. For bonds and preferred stock, Graham suggests calculating the number of times the company earns its total fixed charges. This is done for a number of years. An appropriate result will vary depending on the industry or industries in which the company operates. For instance, to consider a security as investment grade, he suggests a ratio greater than five for a railroad entity. Comparing the enterprise value with the total amount of debt could also serve as an indication of the margin of safety, providing the enterprise value is greater than total debt.
2. Common Stocks. For common stocks, Graham distinguishes three cases.
And finally:
... (1)
where
M.S. = Margin of safety.
P = Price of the asset.
V = Value of the asset.
Let us apply this formula to the recommendation of Benjamin Graham concerning undervalued secondary stocks in which:
So, if you decided to follow Mr. Graham’s advice, you will purchase a secondary stock when the Margin of safety is at least 33, which means it is at least 33 percent undervalued.
Another example. Let us assume that after analyzing and valuing (reasonably well) a hypothetical share, an investor has estimated its value at around $100. The stock is currently exchanged at $80. Since the estimated value is greater than the price of the stock, it is possible to assert that a positive Margin of safety exists, but how large?
By substituting our data into (1):
P=80.
V=100.
=20
In this case the margin of safety is 20. It is also said that the share is 20% undervalued.
Now, suppose that instead of a price of $80 the investor needs to pay $120 per share. By substituting our data into (1):
P=120.
V=100
The margin of safety is a negative 20. It is also said that the share is 20% overvalued, a negative margin of safety, should direct the stock buyer to look somewhere else for an investment opportunity.
Other considerations and conclusion. Placing data into the formula suggested above is the easy part of calculating the Margin of safety. Reaching a figure for the estimated value and deciding
whether the company in question is worth pursuing shows the quality and mettle of the investor.
Also, a figure for the margin of safety which seems appropriate for a company under the so-called “normal conditions” (see above) is generally regarded as not suitable in the phases of mania and panic
of a crisis.
Adequate diversification is another important idea to bear in mind in developing a value investing strategy.
Assessing the margin of safety becomes essential to the strategy of any value investor. Not only does it offer a harbor for analytical errors but also guards us against what are broadly classified as non-systematic and systematic risks. How well will a particular stock perform? It will depend on the magnitude of each of the aforementioned variables.
There is no question than in order to improve our chances, well informed, knowledgeable and experienced analysis and decision making becomes of the essence.
References:
Graham, B. (1973). "The Intelligent Investor: A Book of Practical Counsel." Fourth Revised Edition. New York, NY: HarperCollins Publishers.
Value Investing
In essence, the concept of Value Investing involves buying an asset (stock, bond, real estate, so forth) for a price less than its value (see Figure 1).
So, whenever an individual buys, for instance, a stock for less than its estimated value, he or she is applying this principle.
Margin of Safety
Inherent to value investing is the notion of the "margin of safety." Its importance cannot be over-emphasized. Benjamin Graham (1894-1976), regarded as the father of value investing, coined the term “margin of safety” and considered it to be the Central Concept of Investment (Graham, 1973).
Warren Buffett has stated that: “The Intelligent Investor,” by Benjamin Graham, is by far the best book about investing ever written. He also stressed the importance of chapters 8 (The Investor and Market Fluctuations) and 20 (“Margin of Safety” as the Central Concept of Investment), to avoid poor results from your investments (Graham, 1973). Thus, the greater the margin of safety, the higher the probability of a positive return.
In chapter 20 of “The Intelligent Investor,” Benjamin Graham discusses the margin of safety for two kinds of securities:
1. Bonds and preferred stock. For bonds and preferred stock, Graham suggests calculating the number of times the company earns its total fixed charges. This is done for a number of years. An appropriate result will vary depending on the industry or industries in which the company operates. For instance, to consider a security as investment grade, he suggests a ratio greater than five for a railroad entity. Comparing the enterprise value with the total amount of debt could also serve as an indication of the margin of safety, providing the enterprise value is greater than total debt.
2. Common Stocks. For common stocks, Graham distinguishes three cases.
2.1. Under depression conditions, an investor may consider a stock has a margin of safety when it is selling for less than the corresponding amount of debt that could be safely issued against its property and earning power.
2.2. Under normal conditions (neither under depression nor mania conditions) The Margin of Safety is determined by an expected earning power considerably above the current rate of bonds. Graham offers the following example: A company has an earning power of 9 percent on the price (i.e., This is the reciprocal of the famous ratio), the bond rate is 4 percent. Thus, the stock buyer will have a 5% premium accruing in his favor.
And finally:
2.3. When applied to the field of undervalued or bargain securities (value investing) The margin of safety is defined as favorable difference between value and price (see Figure 2).Formula for Value Investors. In the case of undervalued stocks, an investor could use the following formula:
Notwithstanding that Benjamin Graham suggests the margin of safety as the difference between Value and Price, later on the chapter, he advises the purchase of a secondary company stock when the price is two thirds or less of its value. It is this definition of margin of safety, in relative terms, that personally I find more congruent to work with in the case of undervalued stocks.
... (1)where
M.S. = Margin of safety.
P = Price of the asset.
V = Value of the asset.
Let us apply this formula to the recommendation of Benjamin Graham concerning undervalued secondary stocks in which:
So, if you decided to follow Mr. Graham’s advice, you will purchase a secondary stock when the Margin of safety is at least 33, which means it is at least 33 percent undervalued.
Another example. Let us assume that after analyzing and valuing (reasonably well) a hypothetical share, an investor has estimated its value at around $100. The stock is currently exchanged at $80. Since the estimated value is greater than the price of the stock, it is possible to assert that a positive Margin of safety exists, but how large?
By substituting our data into (1):
P=80.
V=100.
In this case the margin of safety is 20. It is also said that the share is 20% undervalued.
Now, suppose that instead of a price of $80 the investor needs to pay $120 per share. By substituting our data into (1):
P=120.
V=100
The margin of safety is a negative 20. It is also said that the share is 20% overvalued, a negative margin of safety, should direct the stock buyer to look somewhere else for an investment opportunity.
Other considerations and conclusion. Placing data into the formula suggested above is the easy part of calculating the Margin of safety. Reaching a figure for the estimated value and deciding
whether the company in question is worth pursuing shows the quality and mettle of the investor.
Also, a figure for the margin of safety which seems appropriate for a company under the so-called “normal conditions” (see above) is generally regarded as not suitable in the phases of mania and panic
of a crisis.
Adequate diversification is another important idea to bear in mind in developing a value investing strategy.
Assessing the margin of safety becomes essential to the strategy of any value investor. Not only does it offer a harbor for analytical errors but also guards us against what are broadly classified as non-systematic and systematic risks. How well will a particular stock perform? It will depend on the magnitude of each of the aforementioned variables.
There is no question than in order to improve our chances, well informed, knowledgeable and experienced analysis and decision making becomes of the essence.
References:
Graham, B. (1973). "The Intelligent Investor: A Book of Practical Counsel." Fourth Revised Edition. New York, NY: HarperCollins Publishers.
