Margin of Safety

Intrinsic value is independent of the market and current quoted price. 


It is the absolute standard against which all market prices are compared. 

• Thus with the method of valuation, companies are considered neither under-valued nor over-valued relative to the stock market. 

This would be bringing truth to error for correction, a backward approach. 

• Rather, common stock issues are considered either under-priced or over-priced in the market relative to the intrinsic value of their companies. 

This brings error to truth for correction. 

• To identify mispriced stocks, the value of a company is compared to its stock market price.

The concept of price is not without ambiguity. 

• We can choose among closing price, opening price, asking price, bidding price, actual price of latest trade for any number of shares, or actual price of latest trade for the same number of shares in the contemplated transaction.

Thus we focus on the important concept of safety margin rather than emphasize price with its potential quick and large changes from one transaction to the next. 

• The variability of the price of a stock in part represents mispricing by the market. 
• Such lack of convergence of market price to intrinsic value, however transient, represents market inefficiency. 
• The irrationality of the stock market has been observed by de la Vega, John Maynard Keynes, Kindleberger, Lefèvre, Mackay, and others.

John Maynard Keynes in his General Theory (Book IV "The Inducement to Invest", Chapter 12 "The State of Long-Term Expectation", Section V, pages 156-157) introduced the metaphor of newspaper photograph competitions to explain the working of the stock market. 

• His explanation emphasized anticipation of the opinions of other market participants and the resulting infinite regress, i.e., I think that he thinks that I think that he thinks, ad infinitum. 
• This stresses that market prices are determined by opinion.

Safety margin represents an excess of intrinsic value over market price, or alternately, a discount of price below intrinsic value. 

• A safety margin of at least twenty percent is desirable. 
• Intrinsic value is what a company would be worth to a private owner independent of the stock market and its daily quotations. 
• The concept of a margin of safety was introduced by Graham and Dodd in Security Analysis. 

It is more important to wait for a favorable buy price than to be dependent on fortuitous timing to realize a profitable sell price. 

• A buy and hold approach involves more than the platitudinous adage to "buy low and sell high." 
• The margin of safety requires knowing when the buying price is low in absolute terms rather than merely relative to the market as a whole.

http://www.numeraire.com/margin.htm