{"id":5850,"date":"2024-02-14T19:10:24","date_gmt":"2024-02-14T19:10:24","guid":{"rendered":"https:\/\/economicherald.net\/?p=5850"},"modified":"2024-02-14T19:10:24","modified_gmt":"2024-02-14T19:10:24","slug":"what-is-margin-of-safety-and-how-investors-could-use-it-to-find-safer-bets","status":"publish","type":"post","link":"https:\/\/economicherald.net\/?p=5850","title":{"rendered":"What is Margin of Safety, and how investors could use it to find safer bets"},"content":{"rendered":"<p>Warren Buffett is a big believer in Margin of Safety<br \/>\nA margin of safety allows room for error for the investor<br \/>\nSo what is it, and how do you calculate it?<\/p>\n<p>\u00a0<\/p>\n<p>Warren Buffett is a staunch believer in the concept of <strong>\u2018margin of safety\u2019<\/strong> and has declared it as one of his \u201ccornerstones of investing\u201d.<\/p>\n<p>The <em>Oracle of Omaha<\/em> has said time and time again that the more vulnerable a business is, the larger the margin of safety (MOS) you\u2019d need.<\/p>\n<p>\u201cIf you\u2019re driving a truck across a bridge that says it holds 10,000 pounds and you\u2019ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay.<\/p>\n<p>\u201cBut if it\u2019s over the Grand Canyon, you may feel you want a little larger margin of safety,\u201d Buffett said.<\/p>\n<p>In other words, investors should select a stock only if there is sufficient \u201croom for error\u201d, or when the downside risk is protected.<\/p>\n<p>The MOS is essentially a cushion that allows some losses to be incurred, without losing your shirt in one go.<\/p>\n<p>\u00a0<\/p>\n<h2>What is a good margin of safety?<\/h2>\n<p>Buffett says he won\u2019t touch a stock unless the MOS is around 30%.<\/p>\n<p>In other words, even if the stock price drops by 30% today, he still wouldn\u2019t lose money if he held on to the stock long term.<\/p>\n<p>Look at it another way, the MOS is the amount of buffer a company has built through its future revenues versus its stock price today.<\/p>\n<p>If today\u2019s stock price undervalues future revenues, then the margin of safety will be higher for the investor.<\/p>\n<p>\u00a0<\/p>\n<h2>How is MOS calculated?<\/h2>\n<p>The MOS is represented as the percent difference between the current stock price, and the implied fair value per share of the company.<\/p>\n<h2>Margin of Safety = 1 \u2013 (Current Stock Price \/ Intrinsic Value Per Share)<\/h2>\n<p>\u00a0<\/p>\n<p>The key to getting an accurate MOS figure is obviously in calculating a company\u2019s <strong>Intrinsic Value.<\/strong><\/p>\n<p>There are several ways to calculate this, but we\u2019ll describe two here for brevity:<\/p>\n<p>\u00a0<\/p>\n<p><strong>Discount Factor Valuation<\/strong><\/p>\n<p>Buffett obviously prefers the most academic method, which is the Discount Factor method.<\/p>\n<p>This involves extrapolating the company\u2019s cashflow growth, to, say 10 years forward, and discounting it back to present values.<\/p>\n<p>The key here is obviously is in choosing reasonable growth rates to use.<\/p>\n<p>Predicting a reasonable growth rate is a skill in itself, and involves knowing the fundamentals of the company as well as the wider industry.<\/p>\n<p>But growth can also be assumed from historical rates \u2013 i.e. how the company has grown over the past years, or also from the company\u2019s most recent guidance.<\/p>\n<p>\u00a0<\/p>\n<p><strong>Earnings based valuation<\/strong><\/p>\n<p>For the rest of us, an easier way to calculate Intrinsic Value is from data that are already available in the market.<\/p>\n<p><strong>Intrinsic Value = EPS for last 12 months x (1+ growth rate) x P\/E Ratio<\/strong><\/p>\n<p>Here again, a growth rate estimate must also be assumed.<\/p>\n<p>\u00a0<\/p>\n<h2>Examples of ASX stocks with their margin of safety<\/h2>\n<p>Obviously finding a stock with a high enough MOS is like a needle in a haystack, and that\u2019s exactly how it should be.<\/p>\n<p>But here\u2019s a couple of ASX stocks that could have a little bit of margin of safety, although still below Buffett\u2019s benchmark of 30%.<\/p>\n<p>Shoes retailer <strong><a href=\"https:\/\/stockhead.com.au\/company\/accent-group-ax1\/\">Accent (ASX:AX1)<\/a><\/strong> has an MOS of around 18%.<\/p>\n<p><strong>Accent\u2019s MOS = 1 \u2013 (Current Stock Price \/ Intrinsic Value Per Share)<\/strong><br \/>\n<strong>= 1 \u2013 (2.31\/2.84) = 18% (assuming a growth rate of 10%)<\/strong>.<\/p>\n<p><a href=\"https:\/\/stockhead.com.au\/company\/peter-warren-automotive-pwr\/\"><strong>Peter Warren (ASX:PWR)<\/strong><\/a> has an MOS of around 8%.<\/p>\n<p><strong>Peter Warren\u2019s MOS = 1 \u2013 (Current Stock Price \/ Intrinsic Value Per Share)<\/strong><br \/>\n<strong>= 1 \u2013 (2.58\/2.79) = 7.6% (assuming a growth rate of 10%).<\/strong><\/p>\n<p>As always, a single ratio only tells one part of the story for the stock. Investors are advised to study the company in detail both quantitively and qualitatively.<\/p>\n<p>\u00a0<\/p>\n<p>\u00a0<\/p>\n<p><span class=\"et_bloom_bottom_trigger\"><\/span><\/p>\n<p>The post <a href=\"https:\/\/stockhead.com.au\/primers\/what-is-margin-of-safety-and-how-investors-could-use-it-to-find-safer-bets\/\">What is Margin of Safety, and how investors could use it to find safer bets<\/a> appeared first on <a href=\"https:\/\/stockhead.com.au\/\">Stockhead<\/a>.<\/p>","protected":false},"excerpt":{"rendered":"<p>Warren Buffett is a big believer in Margin of Safety A margin of safety allows room for error for the investor So what is it, <a href=\"https:\/\/economicherald.net\/?p=5850\" class=\"read-more-link\">[more&#8230;]<\/a><\/p>\n","protected":false},"author":0,"featured_media":5851,"comment_status":"","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[4],"tags":[],"class_list":["post-5850","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-finance"],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - 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