One of the wealthiest people in the world and the undisputed heavyweight champion of successful investors has actually told us everything we need to know for long-term profitable investing.
With multiple books and countless letters to investors, the co-founder of Berkshire Hathaway has communicated over and over his investing philosophy.
His core investing principle is the Margin of Safety
What Is The Margin of Safety?
If the stock price of a company is below the actual value of the cash flow (income) and assets of a company the percentage difference is the Margin of Safety. This is the discounted price at which you are buying a share in the company.
If a company is worth $5 per share on the stock market exchange, but the value of its earnings, property, and brand is worth $10 then you have a discount of 50%.
If you buy the stock at $5 then eventually the stock price should rise 100% to get to $10 per share.
Simple really! Or is it, how about an infographic to help explain.
If a stock price is significantly below the actual fair value of a company, that percentage difference is known as the Margin of Safety. Essentially the percentage that a company is undervalued by the stock market.
In other words, the Margin of Safety is the percentage difference between a company’s Fair Value per share and its actual stock price. If a company has profits and assets that outweigh a company’s stock market valuation, this represents a Margin of Safety for the investor. The higher the margin of safety the better.
In classic value-investing theory, the margin of safety is the level of risk an investor can live with. The margin of safety is an estimate of the risk a stock buyer takes.
Warren Buffett’s Explanation of Margin of Safety
If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger the margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety. Warren Buffett
The Margin of Safety Formula:
Margin of Safety = (Intrinsic Value Per Share – Stock Price) / Intrinsic Value Per Share
A Practical Example of the Margin of Safety Formula for Small Business:
If you are interested in buying shares of a company, or even entire business, you will want to estimate the value of the cash it generates into the future. In a very simple way, lets guess that a business you want to buy will generate $10,000 per year for 10 years, after the 10 years the business will be worthless. This means the value of the company might be worth today $100,000 minus the yearly inflation rate for example 2% per year.
This means the value of the income in real terms today is $89,826 (Intrinsic Value)
The business owner wants to sell 100% of the company to you for $60,000 (Stock Price)
Margin of Safety = 33% = ($89,826 – $60,000) / $89,826
Using the Margin of Safety Formula for Corporations & Stocks:
Calculating the intrinsic value of a company and therefore the margin of safety there are many more variables and calculations. For this, you will need to use a Margin of Safety Calculator a simple excel spreadsheet.
Key concepts in calculating the intrinsic value in the excel spreadsheet.
Essentially, Warren Buffett estimates the current and predicted earnings from a company from now for the next 10 years. He then discounts the cash flows against for example inflation, to get the current value of that cash. This is the Intrinsic Value of the business.
Explained another way, Warren Buffett bases his Intrinsic Value calculations on future free cash flows as he believes cash is a company’s most important asset, so he tries to project how much future cash a business will generate.
The usual formula for estimating future Free Cash Flows is the Discounted Cash Flow Method. Here is an example of a simple Discounted Cash flow Method
- Take the free cash flow of the first year and multiply it with the expected growth rate.
- Then calculate the NPV of these cash flows by dividing it by the discount rate.
- Project the cash flows 10 years into the future, and repeat steps one and two for all those years.
- Add up all the NPV’s of the free cash flows.
- Multiply the 10th year with 12 to get the sell-off value.
- Add up the values from steps four, five, and Cash & short-term investments to arrive at the intrinsic value for the entire company.
- Divide this number with the number of shares outstanding to arrive at the intrinsic value per share.
Note: the NPV refers to the Net Present Value or the present value of money. You calculate the Net Present Value by subtracting the discount rate from the future value of the money and multiplying it by the number of years you are measuring.
The advantage of the Discounted Cash Flow Method is that it is simple. The problem with this method is that Free Cash flows can vary dramatically over from year-to-year. Thus, the final figure from this method can be innacurate.
The Margin of Safety – What You Should Pay for A Stock
Now that you know what the intrinsic value is per share, you can compare that to the actual share price. If the intrinsic value is more than the actual share price, that would constitute a value investment.
Warren Buffett likes a margin of safety of over 30%, meaning the stock price could drop by 30% and he would still not lose money.
All value investors need to understand that the margin of safety is only an estimate of a stock’s risk and profit potential. There are many risks that fundamental analysis cannot estimate including politics, regulatory actions, technological developments, natural disasters, popular opinion, and market moves.
The margin of safety you use is the level of risk you are comfortable with.
If you are risk-averse, you will want a high margin of safety. A risk-taker, however, could prefer a low margin of safety.
The Margin of Safety Measures Market Irrationality
The larger the margin of safety, the more irrational the market has become. Imagine a business that has $5 billion worth of assets, property and future cash flow from operations, but the stock market values all the shares on the market (Market Capitalization) at $2.5 billion. This essentially means you could buy the entire company for a 50% discount and potentially break to company up and realize a 100% profit on your investment.
If the market values a company accurately, it is behaving rationally. Therefore the larger the Margin of Safety, the more irrational the market is behaving.
Buffett thinks that popular opinion and the media create market irrationality. Buffett watches the news and looks for bad news about good companies. The idea behind this strategy is that news reporting is usually shallow, superficial, and concentrated on one aspect of a company’s business. Buffett will sometimes buy companies after a well-publicized scandal.
Value investors believe people pay more for attractive, fashionable or “sexy” stocks. Therefore, many value investors look closely at unattractive, boring, and unfashionable stocks. These people seek good stocks that the market does not appreciate.
A value investor could buy an oil company instead of a tech stock, for instance. The oil company is old-fashioned, boring, and offensive to some people, but it makes money. The tech company is attractive and flashy, but it could make no money.
Berkshire Hathaway (NYSE: BRK.B) kept large holdings of the banking giant Bank of America (NYSE: BAC) despite a scandal at that company. The public turned on Bank of America after news reports alleged some of its employees were writing fake loans to get commissions.
Buffett kept Bank of America because the bad loans came from one small piece of Bank of America’s business. Buffett’s hope was that the bad news about Bank of America will fade over time, but the company could keep making money.
Another key idea in Buffett’s market irrationality strategy is that the media does a bad job of reporting on companies. Buffett bets that most news about companies will be inaccurate, limited, short-sighted, biased, and incomplete.
Buffett tries to capitalize on that lack of information by having more information than the rest of the market. Buffett reads financial reports; instead of newspapers and blogs, because he thinks financial data gives him an edge over other investors. Buffet assumes that most investors do a poor job of valuing companies because they rely upon inaccurate media reports and his strategy is to find more accurate information and base his decisions on that information.
What is a Good Margin of Safety Ratio?
Most value investors believe that the higher the margin of safety the better. In reality, a margin of safety between 20% and 55% is reasonable. If the margin of safety is too high you must investigate deeper into the company, as it could be that the business has some serious fundamental problems. These problems could range from industry disruption, a catastrophic scandal or even inevitable bankruptcy.
In the next section, we highlight TD Ameritrade a very profitable company with high cash flows that is currently selling at a discount of 55%, e.g. a margin of safety of 55%.
3 Ways of Calculating Margin of Safety & Fair Value
As you can see, the Margin of Safety is entirely dependent on how you calculate the fair value or intrinsic value of a company. The image below shows three ways that fair value can be calculated. This scan was done using our preferred Stock Screener Stock Rover. The red boxes highlight that although there are differences in the fair value calculation, they are in many cases similar outcomes.
You could use the three different ways of calculating Margin of Safety as confirmation that the company is indeed undervalued.
The Three Ways of Calculating Margin of Safety Used By Stock Rover.
Fair Value – We compute the Fair Value of a company by using a discounted cash flow analysis to determine the Intrinsic Value. We then rank firms in each Sector by their Intrinsic Value to find a value that is well suited to current market multiples. Over the long term, our Fair Values will imply a 30% drop in price for the worst stocks and a 45% gain for the best stocks. This is the calculation used by Warren Buffett
Margin of Safety – The percentage difference between a company’s Fair Value and its price. This metric the single most significant valuation metric in our arsenal as it is the final output of detailed discounted cash flow analysis. This is the calculation used by Warren Buffett
Fair Value (EV / Sales) – This fair value determined by ranking stocks in a sector by their EV / Sales ratios. It is a fallback for when discounted cash flow analysis cannot be calculated. Over the long term, this value will imply a 30% drop in price for the worst stocks and a 45% gain for the best stocks.
Margin of Safety (EV to Sales) – The percentage difference between a firms fair value (as determined by the EV / Sales ratio) and its current price. A higher margin of safety is better but this valuation method is imprecise as it uses very generalized criteria.
Fair Value (Academic) – We compute the Fair Value (Academic) of a company by using a discounted cash flow analysis with the academic formula for Intrinsic Value that forecasts cash flows into perpetuity. We then rank firms in each Sector by their Intrinsic Value to find a value that is well suited to current market multiples. Over the long term, our Fair Values will imply a 30% drop in price for the worst stocks and a 45% gain for the best stocks.
Margin of Safety (Academic) – The percentage difference between a company’s Fair Value (Academic) and its price. When this value is close to the non-academic Margin of Safety value it provides higher confidence in the result.
So to reiterate, in the example of TD Ameritrade (above) you can use the three different ways of calculating Margin of Safety as confirmation that the company is indeed undervalued.
Margin of Safety Summary.
Ultimately the calculation of Fair Value and Margin of Safety are critical to the strategy of value investing. If you want to make good profits long-term you need to minimize your risk by purchasing companies that are selling at a strong discount due to market irrationality. We have included an excel spreadsheet to help you calculate fair value and margin of safety manually, but if you want to be effective and efficient you will need a great stock screener with these calculations built-in. Stock Rover offers a full 14-day trial and a free service, try Stock Rover.
[Related Article: 4 Easy Steps to Build The Perfect Warren Buffett Stock Screener]