Buying stocks with a discount to intrinsic value is also commonly referred to as a margin of safety. That term was first made popular by Benjamin Graham in his bestselling The Intelligent Investor, and later on as the main topic of a book by Seth Klarman. For the individual investor trying to beat the market, it’s imperative to craft your own margin of safety formula that aligns with the investing foundation you follow in your stock picking.
Insight from guys like Benjamin Graham and Seth Klarman shouldn’t be taken lightly. In a market where 10% per year is the standard average, Graham’s firm returned a CAGR of 20% from 1936 – 1956 and Klarman’s posted a CAGR of 17% from 1983 – 2014. Graham is credited as Warren Buffett’s biggest investing influence, and Klarman’s book is so coveted that it’s price online is over $1,000.
Now, the task of creating a margin of safety formula isn’t as simple as copying the ones shared in their books. For one, the market is constantly evolving. What worked yesterday rarely works in the future. You also don’t have the advantage of being in the heads of these successful fund managers.
At any time, a large number of stocks could have favorable margin of safety values– with investment in all of them at the same time likely creating over diversification. Selecting which stocks in this group to pick is extremely difficult when you are just blindly following a formula. Conversely, an exuberant bull market could eliminate most if not all of your stock buy signals on a standard margin of safety formula calculation, which could lead to significant opportunity costs.
This is why it’s crucial to craft your own margin of safety formula, one that you could potentially adjust over time to suit your personal needs. Think about the act of blindly following again. Without an understanding of the founding principles involved in a margin of safety calculation– an understanding that can only be mastered through the act of doing– you will have great uncertainty at not only the buy points but also the sell points.
Many investors commonly lament previous decisions when selling too early or too late, and this feeling only intensifies when combined with ignorance and confusion.
So what’s our best option here?
Instead of copying, let’s absorb the main principles behind the way these wildly successful investors crafted their own strategy. The foundations that create stability for the investor caught in the chaotic storm of the market. After all, that’s what a margin of safety is.
#1) A margin of safety formula depends on a discount to intrinsic value
Other than the efficient market cultists, most everyone involved with the stock market can agree that companies don’t always trade at how much they are actually worth. This is what creates incentive to buy, and is the basic idea behind “buy low, sell high”. The market works this way simply because:
–Human beings have a primal need to belong with the crowd for survival
–Human beings are emotional creatures
At the risk of getting too scientific, humans historically relied on tribes working together to provide food and shelter against the harsh elements and predators. Exclusion from the tribe meant almost certain death. We obviously haven’t advanced past these kinds of primal instincts, as fight or flight responses still overtake us even in trivial circumstances.
Humans are also naturally emotional. These emotions can be very contagious. When business and economy booms, both optimism and greed overtake the crowd and spread like an infectious virus. The opposite remains true during recessions. Emotional optimism often causes a stock to be priced much higher than it should, and much lower when fears surround it. Because we’ve seen economic boom and bust cycles for 100s of years, we can expect this to continue into the future.
If we can deduce that a stock isn’t always fairly priced, we can calculate our own value for what the stock is really worth and see if there’s any sort of discount. This depends on the underlying business behind the stock, with business foundations like profits, assets, and debt.
By buying at a discount, we reduce the risk of the investment losing money because if the company isn’t priced at what it’s really worth, that price is likely to eventually catch up at some point. Historically this has proven to be true with many stocks. Reducing the risk creates a sort of moat, a buffer protecting us against adverse situations. Thus the term margin of safety.
Ben Graham liked to use book value when calculating his margin of safety because he saw it as his best chance to reduce risk. Book value gives you the worth of a company’s assets in excess– after all of its liabilities are accounted for. So even in the worst case scenario, one where a company is forced to liquidate its assets and pay out its liabilities, an investment bought at a price below book value would still return a profit to the investor.
I’ll tell you my idea for calculating margin of safety at the end, but if one single principle holds true, it’s that a margin of safety depends on buying at a discount.
#2) A margin of safety formula should not depend on a specific value
This is a potential return crusher, especially if combined with forward earnings estimates. Nothing in the business world is precise.
Earnings can be manipulated, and even legally. Earnings don’t represent cash on hand, and depending on the scheduling of orders and various tax implications, an accountant can sometimes choose how to spread these out over the years to make things look more favorable.
Asset values are largely estimated, especially intangible ones. Many tangible assets are subject to depreciation, which again can vary depending on the appraiser. Though everything in the financial statements are audited, the numbers still depend on several subjective judgment calls from certain individuals.
Don’t get me started on what’s wrong with using future earnings estimates for precise calculations. It’s common for analysts to just be plain wrong.
If anything, valuations and intrinsic values should be calculated in a range. Doing this provides a sufficient margin for error within the estimations themselves. Combine that with the volatility of the business world, customers, interest rates, and results, and it should be clear why you should do this.
Seth Klarman made the same point in Margin of Safety. Even with his vast expertise, Seth stated that business valuation is complex and the values within vary. With so many countless factors influencing outcomes, it’s impossible to predict and difficult to calculate. Thus, being certain you are getting a discount to intrinsic value is also impossible, but there’s ways to greatly increase our chances.
One final downfall that can result from trying to craft a specific intrinsic value number is that it can easily lead to a narrowed focus. In order to create a specific number, the calculations will have to inevitably lean on one or two major metrics. This could be based on price, earnings, balance sheet, operating income or cash flows.
It’s not necessarily wrong to have heavier weights on certain valuations or metrics, but when this leads to blindness on the financials from a complete picture perspective- the results can be disastrous. It’s exactly what led to bankruptcies like Enron.
#3) A margin of safety formula must consider upside as much as downside
Growth is a key when buying stocks. Without growth, a company will not be able to compound share price and dividends paid over the long term. So you want value when it comes to price paid, but you also want a stock with a strong business model and a long track record of success growing earnings and net assets.
The idea that you have to buy stocks before they grow massively is a misnomer. There have been so many cases of companies that steadily grow earnings and net assets over time, and even spanning 3 decades or more. They do this mostly quietly because the growth is responsible and conservative. 15% a year doesn’t create headlines but it does create massive wealth when you are talking about decades.
Because of the many case studies of companies who have had superior compounding for 3 decades or more, it’s very plausible to find a great long term track record of growth and see it still continue for decades longer.
Adding the element of margin of safety to a growth purchase essentially gives the best of both worlds. Earnings may have declined in the short term, thus creating an attractive valuation due to overemphasized fears, but as long as a long term track record is intact… you can feel more confident the greater the discount you get to intrinsic value.
Buying stocks at a discount isn’t an excuse to buy companies with poor business results. Instead it is a complementing feature, to maximize returns in companies with fantastic business results and simultaneously take advantage of the emotional nature and pricing inefficiency of the market.
How to Craft a Personal Formula
With all of these lessons in mind, the first step would be to obtain a deep understanding of the entire annual report (10-k). It may seem overwhelming at first, but we only have to focus on the 3 consolidated statements:
–Cash flow statement
Even then, not every single metric on there needs to be analyzed. Just concentrating on the major aspects within these will both prevent metric tunnel vision and give the best picture of a company’s overall financial health and valuation. This general valuation will give us the sufficient margin of safety we seek. Major metrics within the consolidated statements can best be summed with, respectively:
Of course there’s a little more to it than just that, and several metrics combine other details with these main themes. Each person’s favored valuations to compose a margin of safety formula may be different, but everyone’s should cover these 3 themes in one way or another. They are basically ensuring the company is (1) turning a profit, (2) building assets and limiting debt, and (3) keeping enough short term liquidity on hand.
The valuations I use are explained in my investing for beginners 7 step guide, and each individual value based ratio in there is used and combined to create my own margin of safety formula.
The next step is to determine at what scale each ratio will contribute to the calculation. Again, avoid too much dependence on one single metric. My strategy tends to weight heavier on price, as this helps me find my discount to intrinsic value. I don’t try to calculate a stock’s intrinsic value, but I do ensure that the price for the stock is attractive based on all of the price based metrics. What this does is identify problems within the business model without having to use the nitty gritty details in the 10-k.
For example, if a stock has a very low P/S but very high P/E, that means the company has plenty of sales but little earnings– indicating poor profit margins. What’s nice about my valuation formula [the Value Trap Indicator] is that you don’t have to know these specifics if you don’t want to. By simply assuring adequate ratio ranges everywhere, and not allowing even one red flag, you mitigate many of the intricate problems within business financials without spending hours to dissect every 10-k.
Once a sufficient discount or fair price compared to intrinsic value is established, the final step is to ensure that the company has an adequate growth history. How long you search for outstanding growth should depend on current market conditions. The number of opportunities available at that time should help you determine how much growth to settle for.
I’m a big proponent of dollar cost averaging. A potential downside to this is being forced to buy stocks at inopportune times. However, the benefits severely outweigh the negatives. By preventing myself from hoarding cash, I take away any sort of market timing skill from affecting my returns and earn steady income while doing so.
Ben Graham vehemently discourages investors from trying to time the market. I strongly agree especially because it doesn’t look like a sustainable long term approach.
Part of dollar cost averaging each month means that the discount to intrinsic value is a moving target. For example, a P/E of 15 may be a steal when the market average is 25 but a poor choice when it is at 10. This is obviously an oversimplification and may not be the case at all depending on the rest of the financials.
But this idea… that how valuable a certain discount to intrinsic value is constantly changes… means that a margin of safety or intrinsic value formula can’t be attached to a singular number. An arbitrary rule like only buying P/B’s below 1.5 may create better results in certain markets than in others.
And… we don’t know how the business environment will change in the future. Principles will always remain the same– like buying with a margin of safety to take advantage of fear and greed– but its applications will always evolve.
Which reinforces the central thesis to this article. Creating a personal margin of safety formula is so important because as the landscape changes, so does the application of these basic principles. Warren Buffett learned his value investing foundations from Graham, but he evolved his approach with time and continues to– to this day.