Thursday, 12 July 2012

Margin of Safety — Your Safety Net

Stock valuation is not an objective science — you cannot just plug in numbers and come up with a price set in stone. There is a lot of subjectivity around it such as your familiarity with the industry and the company, your projections on the future of the company, your evaluation of management competency, etc.

So if the outcome of the valuation process is so uncertain, do we even need to bother doing all the work?

We think it is well worth it. The process forces you to think about and research the company, its structure and functioning, the way it generates cash. We recognize the probabilities associated with the final price. As an added level of protection, we use a margin of safety.

What is Margin of Safety?
Let's consider an example.

When engineers design a bridge, several variables go into their calculations. The bridge needs to hold up against the heaviest load allowed and should also be strong enough to overcome normal wear and tear over the years.

A bad design will lead to failure, which would be disastrous. That's why, when choosing the material and its thickness in the design phase, engineers use what is called a factor of safety to minimize the probability of failure.

So they estimate, for example, the highest load the bridge would encounter. Then they bump this number up by multiplying it with a factor — the factor of safety. Now the bridge may never ever have to bear such load, but it still is designed for that.

A bridge is a complex engineering structure requiring intricate design. What if some of the assumptions in the design were wrong or off target? The factor of safety helps guard against inaccurate assumptions.

In stock investing, margin of safety behaves identically to the factor of safety in mechanical design.

When you value a stock, you use certain assumptions on the future of the company. As time goes by, some of these assumptions will most likely be off. Using a margin of safety on the estimated price helps reduce potential losses.

How Do We Use Margin of Safety?
Let's say you're doing your valuation on a company that owns a chain of restaurants. You come up with a fair price of $25.

Let's also say that you are very familiar with the restaurant business and have actually worked in that field. You've even gone out to eat several times at this particular chain. You feel fairly confident that this restaurant has the potential to continue it's profitable streak.

What price should you buy the stock at?

No matter how well you know the business, the future will not play out exactly like you've assumed. So we don't think you should buy it at $25.

How much of a discount margin should we apply? Since you're pretty familiar with the business and have done good research, you could probably use a discount margin of 20 to 30%. In other words, you could buy the stock for 70 to 80% of your estimated price, which works out to $17.50 to $20.

This 20 to 30% discount is your margin of safety.

The less confident you are in your assumptions, the higher the margin that should be applied. We tend to use 30 to 50% (i.e. we shoot for a price that is 50-80% of our estimated price).

In addition, think of what would happen if your assumptions turn out to be fairly conservative and the company does much better than you assumed. That discount margin now boosts your returns significantly!

In summary, we discussed what exactly margin of safety is and why we need it. We looked at an example to help us apply this concept.

Your discount margin will depend on your familiarity with the company, the quality of its fundamentals, how good its management is, and your projection of its future business growth, among other factors. The more uncertain you think your price estimate is, the higher the margin you should use.

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