Margin of Safety
A central idea in value investing
The margin of safety is a central idea in value investing. Originally coined by Benjamin Graham, there are now a number of variations on the idea.
It is calculated as the difference between the calculated intrinsic value
of a company compared to its stock price at any time.
This is usually expressed as a percentage.
Kenton K. Yee, in an article in the Journal of Investing, suggested that ... "while investors should demand a margin of safety that is typically 10% to 25% of the share price, larger margins are justified for especially risky stocks".
Putting this another way, the price you pay for a stock should generally be 10% to 25% below the calculated intrinsic value - or more for riskier stocks.
For those of us who shy away from calculating intrinsic value, Benjamin Graham's requirements indicated below provide an alternative checklist ...
Adequate Company Size
Companies vary markedly in size which is commonly measured by market capitalization (or market cap) - the number of shares issued times the price per share.
As a general rule, the larger the company, the less likely it will fail - except for the occasional exception! So for more conservative investors, one way to build in a margin of safety is to pick from the top 200 to 300 companies.
Strong Financial Position
Conservatively financed companies are less likely to fail than those that are more aggressively financed. There are a couple of ways to tell the difference.
Working capital is one of them. This is the difference between current assets and current liabilities. The current ratio measures working capital as it is the current assets divided by the current liabilities. This ratio is displayed for each company on my online broker's website.
A reasonable value for this ratio is considered to be 1.5 which means that current assets are half as much again as current liabilities.
The greater the ratio, the more conservatively financed the business. However, if this ratio gets in the region of 2.0 or beyond, it may be considered to have a lazy balance sheet.
Also, a conservatively geared business will commonly have a debt to equity ratio less than 0.5 (or 50 percent). This ratio is also displayed for each company on my online broker's website.
Sticking with conservatively financed and conservatively geared companies is another way to build in a margin of safety.
Stable or increasing earnings provide a platform for dividends and/or share price growth. If a company does not have a 10-year profit record, then it is difficult to support a margin of safety.
Earnings stability can also be measured in terms of earnings per share growth over time. The greater the earnings stability, the greater the confidence an investor can have in earnings forecasts. The stock market is a forward looking beast!
Good Dividend Record
The margin of safety requirement here is that the company has a 10-year record of uninterrupted dividend payment. Even better if the dividend is growing over time!
Good Earnings Growth
Benjamin Graham looked for at least a 33% increase in earnings per share over a 10-year period. He took the average of the first three years and compared it to the average of the last three years.
((Av. Last 3 yrs - Av. First 3 yrs)/Av. First 3 yrs )* 100.
The greater the earnings per share growth above 33%, the happier a growth investor would be.
Moderate Price to Asset Ratio
Graham's guideline here was that the investor should not pay more that 1.5 times the book value at the end of the last reported year.
He qualified this to suggest that if the price earnings ratio was low then a higher book value may be justified. His rule of thumb was that the product of the two should not exceed 22.5.
Book value X P/E ratio < 22.5
Moderate Price Earnings Ratio
Graham's rule was that an investor should not pay more than 15 times the average earnings per share for the last three years. Averaging over three years evens out earnings fluctuations that may occur.
Warren Buffett Additions
From what I have gleaned about Warren Buffett's stock-picking strategies, particularly from reading Buffett Beyond Value by Prem C. Jain, Buffett would support many of the recommendations of Benjamin Graham relating to value. He would also place emphasis on excellent management and the likelihood of strong prospects of future growth.
Picking the best managers who can drive future growth is not always an easy task for 'outsiders'. But if a company can deliver strong (above sector) earnings per share growth over a 10-year period or more, as well as delivering high return on equity in this time frame, then this must say something about the management.
To Conclude ...
The concept of margin of safety, first highlighted by Benjamin Graham and refined further by Warren Buffett, provides a means for value investors (like me) to minimize risk and safeguard capital.
While margin of safety can be calculated by comparing intrinsic value to the current share price, the above seven recommendations of Benjamin Graham provide an additional means to judge whether the current price of a share represents 'good value'.
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