Question

What should be the margin of safety if the amount of the discount below the fundamental or intrinsic value? please use your own words and no handwriting, thanks!

Answer 1

The purpose of estimating intrinsic value is to take advantage of mis-priced assets. If the market value of an asset is below intrinsic value then the investor might consider owning the asset. If the market value of an asset is above intrinsic value then the investor should choose to not own the asset.

The required margin of safety is the amount of discount (below the intrinsic value) an investor desires in order to purchase the asset. A value investor searches for assets with the greatest margin of safety. That means finding assets with a market price far below the investor’s perceived intrinsic value.

The degree of difficulty in estimating intrinsic value varies greatly among different assets. For example, the intrinsic value of a bond is easier to calculate than its corresponding equity stock. A bond has set cash flow and set duration. Therefore, cash flow and growth are usually fixed. The only variable is the amount the analyst chooses to discount the risks of the bond coupon (interest) not being paid and the cost of capital.

A stock has many more variables, both tangible and intangible, that can affect future cash flow, growth, and the discount for risk. All things being equal, you will require a larger margin of safety for a stock than for a bond.

The tangible assets of intrinsic value are available for analysis because this is the purpose of financial statements. But financial statements can’t reflect the true value of intangible assets such as proprietary technology, trademarks, patents, brands, research and development, good or bad management, competitive advantages, etc. Many times intangibles would be the cause of the greatest disparities between intrinsic values, market values, and book values.

Don’t get discouraged because you feel it’s difficult to determine the intrinsic value of a stock. It is not a science! Any calculations that involve the future are subject to a wide margin of error. There are too many variables and possible end results for anyone to be expected to make precise calculations of intrinsic value.

In fact it is those variables that make up your estimated intrinsic value that are more important than an exact intrinsic value number. So don’t get too fixated on an exact number. The best analysts will have a clear understanding of the variables. It is the variables that determine your required margin of safety.

The required margin of safety is the amount of discount (below the intrinsic value) an investor desires in order to purchase the asset. A value investor searches for assets with the greatest margin of safety. That means finding assets with a market price far below the investor’s perceived intrinsic value.
Here is the important concept: After determining a reasonable range for intrinsic value, require a sufficient margin of safety to allow for unforeseen problems and/or your mistakes. In other words, the wider the range of your estimated intrinsic value then the larger your required margin of safety.

High uncertainty in intrinsic value combined with a small margin of safety equals high risk. Low uncertainty combined with a large margin of safety equals low risk.

It’s helpful to approach risk a little differently. Think about searching for investments in which the perceived risk is greater than the real risk. Usually this means the price is lower than the real value. You would want to avoid investments where the perceived risk is less than the real risk. In this case the stock would probably be overpriced.

Ultimately low risk means having a sufficient margin of safety! The best risk/reward ratio investments are found by purchasing assets at prices far below their intrinsic value. In other words, finding mis-priced securities is the best approach to lowering risk and increasing returns.

Calculating a company’s intrinsic value or producing an estimate of intrinsic value is essential if you want to avoid falling into a value trap.

When it comes to calculating a company’s intrinsic value, the preferred method is usually the discounted cash flow analysis.

Using the DCF analysis has both advantages and disadvantages. When used correctly, with an appropriate margin of safety built into all the figures, the valuation metric can be extremely helpful. However, when overly optimistic numbers, growth rates and a lower than average discount rate is applied, the DCF calculation can throw out an estimate of intrinsic value that is far above what the actual business is worth.

When putting together assumptions for business growth when calculating a DCF, it is essential to be extremely skeptical. Estimated cash flows two, three or five years in advance are never going to be 100% correct because they are estimates and it is important to understand that there will be both an upside and downside to these estimates.

Just because a business has been able to grow earnings and cash flow at 15% per annum for the last five years does not make it a certainty that this growth will continue.

It is also imperative to use a conservative discount rate in the DCF computation.

The discount rate can be thought of as the interest rate you require for taking on the risk of owning the stock. The more confident you are about a business's future cash flow, the lower the discount rate can be.

Most of the value investors I have encountered do not use a discount rate of less than 10%, which adds yet another layer of safety into growth estimates.

The margin of safety principle compliments the conservative calculation of intrinsic value perfectly. As a calculation of intrinsic value can never be 100% perfect, the margin of safety gives you a cushion, so that even if you are 20% off your estimate of intrinsic value you still stand to make a profit.

For example, say that you calculate the intrinsic value of company X as being $100 a share, if you look for a margin of safety of 50% and by in that $50 a share, even if the stock peaks at $80 before earnings start to stagnate, a possible upside of 60% is still available.