You must predict the future, yet the future is not reliably predictable.

The difficulty of predicting the future even a few years ahead. 

An unresolvable contradiction exists: to perform present value analysis, you must predict the future, yet the future is not reliably predictable. 

The miserable failure in 1990 of highly leveraged companies such as Southland Corporation and Interco, Inc., to meet their own allegedly reasonable projections made just a few years earlier-in both cases underperforming by more than 50 percent-highlights the difficulty of predicting the future even a few years ahead. 

Investors are often overly optimistic in their assessment of the future. 

A good example of this is the common response to corporate write-offs. This accounting practice enables a company at its sole discretion to clean house, instantaneously ridding itself of underperforming assets, uncollectible receivables, bad loans, and the costs incurred in any corporate restructuring accompanying the write-off. 

Typically such moves are enthusiastically greeted by Wall Street analysts and investors alike; post-write-off the company generally reports a higher return on equity and better profit margins. Such improved results are then projected into the future, justifying a higher stock market valuation. 

Investors, however, should not so generously allow the slate to be wiped clean. When historical mistakes are erased, it is too easy to view the past as error free. It is then only a small additional step to project this error-free past forward into the future, making the improbable forecast that no currently profitable operation will go sour and that no poor investments will ever again be made. 

How do value investors deal with the analytical necessity to predict the unpredictable? 

The only answer is conservatism. 

Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb. Virtually everything must go right, or losses may be sustained. 

Conservative forecasts can be more easily met or even exceeded. 

Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom.

Margin of Safety

The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. 

If the margin is a large one, then it is enough to justify the assumption that future earnings will roughly approximate those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.

Excellent comments on Margin of Safety by Warren Buffett

Warren Buffett explains Margin of Safety

https://youtu.be/hZQNnDHlQZQ

The Importance of Trading: Since transacting at the right price is critical, trading is central to value-investment success.

There is nothing inherent in a security or business that alone makes it an attractive investment.

Investment opportunity is a function of price, which is established in the marketplace.

• Whereas some investors are company- or concept-driven, anxious to invest in a particular industry, technology, or fad without special concern for price, a value investor is purposefully driven by price. 
• A value investor does not get up in the morning knowing his or her buy and sell orders for the day; these will be determined in the context of the prevailing prices and an ongoing assessment of underlying values. 

Since transacting at the right price is critical, trading is central to value-investment success. 

• This does not mean that trading in and of itself is important; trading for its own sake is at best a distraction and at worst a costly digression from an intelligent and disciplined investment program. 
• Investors must recognize that while over the long run investing is generally a positive sum activity, on a day-to-day basis most transactions have zero sum consequences. If a buyer receives a bargain, it is because the seller sold for too low a price. If a buyer overpays for a security, the beneficiary is the seller, who received a price greater than underlying business value. 

The best investment opportunities arise when other investors act unwisely thereby creating rewards for those who act intelligently. 

• When others are willing to overpay for a security, they allow value investors to sell at premium prices or sell short at overvalued levels. 
• When others panic and sell at prices far below underlying business value, they create buying opportunities for value investors. 
• When their actions are dictated by arbitrary rules or constraints, they will overlook outstanding opportunities or perhaps inadvertently create some for others. 

Trading is the process of taking advantage of such mispricings.

Value Pretenders

A broad range of strategies make use of value investing as a pseudonym.  Many have little or nothing to do with the philosophy of investing originally espoused by Graham.

The long-term success of true value investors such as Buffett at Berkshire Hathaway and others, attracted a great many "value pretenders," investment chameleons who frequently change strategies in order to attract funds to manage.

• These value pretenders are not true value investors, disciplined craftspeople who understand and accept the wisdom of the value approach.  
• Rather they are charlatans who violate the conservative dictates of value investing, using inflated business valuations, overpaying for securities, and failing to achieve a margin of safety for their clients.

These investors, despite (or perhaps as a direct result of ) their imprudence, are able to achieve good investment results in times of rising markets.

• During the latter half of the 1980s, value pretenders gained widespread acceptance, earning high, even spectacular returns.  
• Many of them benefited from the overstated private-market values that were prevalent during those years; when business valuations returned to historical levels in 1990-, however, most value pretenders suffered substantial losses.

To some extent, value like beauty, is in the eye of the beholder; virtually any security may appear to be a bargain to someone.  

• It is hard to prove an overly optimistic investor wrong in the short run since value is not precisely measurable and since stocks can remain overvalued for a long time.  
• Accordingly, the buyer of virtually any security can claim to be a value investor at least for a while.

Many true value investors fell into disfavour during the late 1980s.  

• As they avoided participating in the fully valued and overvalued securities that the value pretenders claimed to be bargains, many of them temporarily underperformed the results achieved by the value pretenders.  
• The most conservative were actually criticized for their "excessive" caution, prudence that proved well founded in 1990.

Even today, many of the value pretenders have not been defrocked of their value-investor mantle.

What is an appropriate margin of safety?

Even among value investors, there is ongoing disagreement concerning the appropriate margin of safety.



Some highly successful investors increasingly recognize the value of intangible assets.

Some highly successful investors, including Buffett, have come increasingly to recognize the value of intangible assets - broadcast licenses or soft-drink formulas, for example - which have a history of growing in value without any investment being required to maintain them.  Virtually all cash flow generated is free cash flow.



The problem with intangible assets, is that they hold little or no margin of safety. 

The most valuable assets of Dr Pepper/Seven-Up, Inc., by way of example, are the formulas that give those soft drinks their distinctive flavours.  It is these intangible assets that cause Dr Pepper/Seven-Up, Inc., to be valued at a high multiple of tangible book value.  If something goes wrong - tastes change or a competitor makes inroads - the margin of safety is quite low.



Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection from loss.  

Tangible assets usually have value in alternate uses, thereby providing a margin of safety.  If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated, receivables collected, leases transferred, and real estate sold.  If consumers lose their taste for Dr Pepper, by contrast, tangible assets will not meaningfully cushion investors' losses.

The Importance of a Margin of Safety

Benjamin Graham has no interest in paying $1 for $1 of value; only interested in buying at a substantial discount from underlying value.

Benjamin Graham understood that an asset or business worth $1 today could be worth 75 cents or $1.25 in the near future.

He also understood that he might even be wrong about today's value.

Therefore Graham had no interest in paying $1 for $1 of value.  There was no advantage in doing so, and losses could result.

Graham was only interested in buying at a substantial discount from underlying value.

By investing at a discount, he knew that he was unlikely to experience losses.

The discount provided a margin of safety.



Investors need a margin of safety

Because investing is as much an art as a science, investors need a margin of safety.

A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for 

• human error, 
• bad luck, or 
• extreme volatility 

in a complex, unpredictable, and rapidly changing world. 

According to Graham, "The margin of safety is always dependent on the price paid.  For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price."

Buffett described the margin of safety concept in terms of tolerances:  "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it.  And that same principle works in investing."



What is the requisite margin of safety for an investor? 

The answer can vary from one investor tot he next.

• How much bad luck are you willing and able to tolerate?  
• How much volatility in business values can you absorb?  
• What is your tolerance for error?  

It comes down to how much you can afford to lose.

Most investors do not seek a margin of safety in their holdings.

Institutional investors who buy stocks as pieces of paper to be traded and who remain fully invested at all times fail to achieve a margin of safety.

Greedy individual investors who follow market trends and fads are in the same boat.

The only margin investors who purchase Wall Street under-writings or financial-market innovations usually experience is a margin of peril.  

Should investors worry about the possibility that business value may decline?

1.  Should investors worry about the possibility that business value may decline? 

Absolutely.



2.  Should they do anything about it? 

There are three responses that might be effective.

• First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.
• Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or to hold current positions.  This means that normally selective investors would probably let even more pitches than usual go by.
• Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value.  In a deflationary environment, if you cannot tell whether or when you will realize underlying value, you may not want to get involved at all.  If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause value to diminish become moot.

Concept of Interest Coverage is akin to Concept of Margin of Safety

INTEREST COVERAGE

Interest Coverage:  This is the number of times that interest charges are earned, found by dividing the (total) fixed charges into the earnings available for such charges (either before or after deducting income taxes).

Interest Coverage
=  Earnings (before or after income tax) / total interest charges



MARGIN OF SAFETY

Margin of Safety, in general, is the same as "interest coverage."

Formerly used in a special sense, to mean the ratio of the balance after interest, to the earnings available for interest.

Margin of Safety
= Balance of earnings after interest / Earnings available for interest.

For example:

Interest  $100
Earnings  $175

Interest cover $175/$100 = 1.75x
Balance after interest = $175 - $100 = $75

The margin of safety (in this special sense) becomes
= $75 / $175
= 42.86%

Understand the Intrinsic Value

Intrinsic Value is the "real value" behind a security issues, as contrasted with its market price. 

Generally a rather indefinite concept; but sometimes the balance sheet and earnings record supply dependable evidence that the intrinsic value is substantially higher or lower than the market price.


Benjamin Graham

Focus investor and Risk

In contrast to the diversified stockholder, the focus investor will ordinarily demand a significant margin of comfort prior to allocating substantial funds to a single stock. Fear of loss can concentrate the mind wonderfully, and the investor staking a large proportion of his or her total funds on only one security is more likely to rigorously scrutinize this potential investment.

As Buffett summarizes, a policy of portfolio concentration should serve to increase “both the intensity with which an investor thinks about a business and the comfort-level he must feel
with its economic characteristics before buying into it.”

Focusing on only a handful of stocks should not, therefore, increase portfolio “ risk,” at least as it is defined by the layperson—that is, the possibility of incurring financial loss.

• The intelligent investor will only select those stocks that exhibit the largest shortfall between quoted price and perceived underlying value—that is, those securities that are likely to provide the greatest margin of safety against financial loss in the long term. 
• Although a compact suite of stocks will be undeniably more volatile than a diversified holding, short-term price fluctuations are of little concern to a long-term holder of stocks who focuses on income rather than capital appreciation.
• Indeed, value investors favor those stocks that display the potential for extreme volatility— the difference is that these investors expect predominantly upside volatility.

Risk, for value investors, is not a four-letter word—it is embraced and addressed proactively, not defensively

Value of a Business to a Private Owner

Value of a Business to a Private Owner Test

The private-owner test would ordinarily start with the net worth as shown in the balance sheet.


How to search for a bargain opportunity?

1.  Using the net worth as the starting point

The question to ask is:  Is the indicated earnings power sufficient to validate the net worth as a measure of what a private buyer would be justified in paying for the business as a whole?

If the answer is definitely yes, an ordinary investor should find the common stock attractive at a price one-third or more below such a figure.  


2.  Using the working capital as the starting point

If instead of using all the net worth as a starting point, the investor considered only the working capital and applied his test to that, he would have a more convincing demonstration of the existence of a bargain opportunity.

For it is something of an axiom or is self evident, that a business is worth to any private owner AT LEAST the amount of its working capital, since it could ordinarily be sold or liquidated for more than this figure.

If a common stock can be bought at no more than two-thirds of the working capital value alone - disregarding all the other assets - and if the earnings record and prospects are reasonably satisfactory, there is strong reason to believe that the investor is getting substantially more than his money's worth.



An example of how to find a bargain common stock:

[Peculiarly, in 1947, many such opportunities present themselves in ordinary markets.  Benjamin Graham]

National Department Stores as of January 31, 1948, the close of its fiscal year.
The price of the stock was 16 1/2.
The working capital was no less than $26.60 per share.
The total asset value was $33.30.
Deducting contingency reserves - mainly to mark down the inventory to a "LIFO" (last in first out) basis, these figures would be reduced by $2.20 per share.

The company had earned $4.12 per share in the year just closed.  The seven-year average was $3.43; the twelve-year average was $2.29.  (Growing earnings)
The year's dividend had been $1.50.  (Paying dividends)
Compared with a decade before,
-  the working-capital value had risen from $7.40 per share to $26.60,
-  the sales had doubled and (Increasing sales)
-  the net after taxes had risen from $654,000 to $3,224,000.  (Increasing profits)


Thus, we had a business
-  selling for $13 million,
-  with $25 million of assets, mostly current.  (Price < Net Assets)
-  Its sales were $88 million.  A fair estimate of average future earnings might be $2 million. (earnings record and prospects are reasonably satisfactory  or Not gruesome)

The average earnings prior to 1941 had been unimpressive, and the company was regarded as a "marginal" one in its field - that is, it could earn a reasonably good return only under favourable business conditions.  (Qualitative assessment)

In the past eight years, however, it has improved both in financial strength and in the quality of its management.  (Qualitative assessment - earnings record and prospects are reasonably satisfactory or improving quality of business and management)

Let us grant that Wall Street would still consider the company as belonging in the second rank of department-store enterprises.  (Investor sentiment/Market sentiment/Neglected by market)

Even after proper allowance is made for such an unfavourable factor, we may still conclude that on the basis of the figures the stock is intrinsically worth well above its market price.  (Worse case scenario, still Value > Price)


Conclusion:  At 16 1/2, the conclusion in the case of National Department Stores remains, whether we apply the appraisal test or the test of value to a private owner.  (Undervalued / A bargain)

Avoid buying these securities when available at full prices

In selecting investments, in terms of psychology as well as arithmetic, we are guided by three requirements of:

1. underlying safety,
2. simplicity of choice, and
3. promise of  satisfactory results.

Using these criteria has led to the exclusion from the field of recommended investment a number of security classes which are normally regarded as suitable for various kinds of investors.

INVESTMENTS TO AVOID AT FULL PRICES

Advised against the purchase at FULL PRICES of three important categories of securities:

(a) foreign bonds;

(b) ordinary corporate bonds and preferred stocks, under present conditions of relative yield when the best grade issues yield little more than his US Savings Bonds;

(c) secondary common stocks, including, original offerings of such issues.

By full prices, we mean 

• prices close to par for bonds or preferred stocks, and 
• prices that represent about the fair business value of the enterprise in the case of common stocks.

ADVICE FOR DEFENSIVE INVESTORS

The greater number of defensive investors are to avoid these categories REGARDLESS OF PRICE.

ADVICE FOR ENTERPRISING INVESTORS

Enterprising investors are to buy them only when obtainable at BARGAIN PRICES - which is defined as prices not more than two-thirds of the appraisal value of the securities.

REASONINGS

FOREIGN GOVERNMENT BONDS

Why people buy and why they should avoid purchasing foreign Government bonds?  

• They wanted "just a little more income."  The country seemed like a good risk - and that was enough.  The purchasers of the foreign Government bonds must have told themselves that the bonds are practically riskless, presumably on the ground that the country was a far different kind of debtor than other know riskier countries.  
• At times, the buyer was obtaining just a slight percentage more on his money than the yield on AAA corporate bonds - and this hardly enough to warrant the assumption of a recognized risk.  
• By what process of calculation could the buyers of the foreign Government bonds assure themselves that at no time before their maturity date, would that country suffer severe economic, or internal political, or international problems?  Also, the high interest rates themselves helped to make default inevitable, especially in distressed countries offering by high interest on their foreign Government bonds.

CORPORATE BONDS OR PREFERRED STOCKS

How to entice people to buy corporate bonds or preferred stocks?  

          For corporate bonds and preferred stocks to be bought, these would either 

• have to increase their yields so as to offer a reasonable alternative to US Savings Bonds for individual investors or 
• else would be bought solely by financial institutions - insurance companies, savings banks, commercial banks, and the like,  Such institutions have their own justification for buying corporate securities at current yields.

SECONDARY COMMON STOCKS

How and when to buy secondary common stocks?  

• Secondary issues, for the most part, do fluctuate about a central level which is well below their fair value.  They reach and even surpass that value at times; but this occurs in the upper reaches of bull markets, when the lessons of practical experience would argue against the soundness of paying the prevailing prices for common stocks.  The aggressive investor should accept the central market levels which are normal for that class as their guide in fixing own levels for purchase.  Financial history says clearly that the investor may expect satisfactory results, on the average, from secondary common stocks only if he buys them for less than their value to a private owner, that is, on a bargain basis. 
• [There is a paradox here, nevertheless.  The average well-selected secondary company may be fully as promising as the average industrial leader.  What the smaller concern lacks in inherent stability it may readily make up in superior possibilities of growth.  Consequently, it may appear illogical to many readers to term "unintelligent" the purchase of such secondary issues at their full "enterprise value."  ]

Intelligent Investor

Benjamin Graham

Stock Valuation Manifesto Checklist

September 11, 2017 | Vishal Khandelwal  

https://www.safalniveshak.com/stock-valuation-manifesto/

I had released my Investor’s Manifesto couple of years back. Now, here is my fifteen-point stock valuation manifesto that I penned down a few months back though I have been using it as part of my investment process for a few years now.

It is evolving but is something I reflect back on if I ever feel stuck in my stock valuation process. You may modify it to suit your own process and requirements. But this in itself should keep you safe.

Read it. Print it. Face it. Remember it. Practice it.

[Your Name]’s Stock Valuation Manifesto

1. I must remember that all valuation is biased. I will reach the valuation stage after analyzing a company for a few days or weeks, and by that time I’ll already be in love with my idea. Plus, I wouldn’t want my research effort go waste (commitment and consistency). So, I will start justifying valuation numbers.
2. I must remember that no valuation is dependable because all valuation is wrong, especially when it is precise (like target price of Rs 1001 or Rs 857). In fact, precision is the last thing I must look at in valuation. It must be an approximate number, though based on facts and analysis.
3. I must know that any valuation method that goes beyond simple arithmetic can be safely avoided. If I need more than four or five variables or calculations, I must avoid that valuation method.
4. I must use multiple valuation methods (like DCF, Dhandho IV, exit multiples) and then arrive at a broad range of values. Using just a single number or method to identify whether a stock is cheap or expensive is too much oversimplification. So, while simplicity is a good habit, oversimplifying everything may not be so.
5. If I am trying to seek help from spreadsheet based valuation models to tell me whether I should buy, hold, sell, or avoid stocks, I am doing it wrong. Valuation is important, but more important is my understanding of the business and the quality of management. Also, valuation – high or low – should scream at me. So, I may use spreadsheets but keep the process and my underlying thoughts simple.
6. I must remember that value is different from price. And the price can remain above or below value for a long time. In fact, an overvalued (expensive) stock can become more overvalued, and an undervalued (cheap) stock can become more undervalued over time. It seems harsh, but I cannot expect to fight that.
7. I must not take someone else’s valuation number at face value. Instead, I must make my own judgment. After all, two equally well-informed evaluators might make judgments that are wide apart.
8. I must know that methods like P/E (price to earnings) or P/B (price to book value) cannot be used to calculate a business’ intrinsic value. These can only tell me how much a business’ earnings or book value are priced at vis-à-vis another related business. These also show me a static picture or temperature of the stock at a point in time, not how the business’ value has emerged over time and where it might go in the future.
9. I must know that how much ever I understand a business and its future, I will be wrong in my valuation – business, after all, is a motion picture with a lot of thrill and suspense and characters I may not know much about. Only in accepting that I’ll be wrong, I’ll be at peace and more sensible while valuing stuff.
10. I must remember that good quality businesses often don’t stay at good value for a long time, especially when I don’t already own them. I must prepare in advance to identify such businesses (by maintaining a watchlist) and buy them when I see them priced at or near fair values without bothering whether the value will become fairer (often, they do).
11. I must remember that good quality businesses sometimes stay priced at or near fair value after I’ve already bought them, and sometimes for an extended period of time. In such times, it’s important for me to remain focused on the underlying business value than the stock price. If the value keeps rising, I must be patient with the price even if I need to wait for a few years (yes, years!).
12. Knowing that my valuation will be biased and wrong should not lead me to a refusal to value a business at all. Instead, here’s what I may do to increase the probability of getting my valuation reasonably (not perfectly) right –
    
    
    
    • I must stay within my circle of competence and study businesses I understand. I must simply exclude everything that I cannot understand in 30 minutes.
    • I must write down my initial view on the business – what I like and not like about it – even before I start my analysis. This should help me in dealing with the “I love this company” bias.
    • I must run my analysis through my investment checklist. I have seen that a checklist saves life…during surgery and in investing.
    • I must, at all cost, avoid analysis paralysis. If I am looking for a lot of reasons to support my argument for the company, I am anyways suffering from the bias mentioned above.
    • I must use the most important concept in value investing – margin of safety, the concept of buying something worth Rs 100 for much less than Rs 100. Without this, any valuation calculation I perform will be useless. In fact, the most important way to accept that I will be wrong in my valuation is by applying a margin of safety.
13. Ultimately, it’s not how sophisticated I am in my valuation model, but how well I know the business and how well I can assess its competitive advantage. If I wish to be sensible in my investing, I must know that most things cannot be modeled mathematically but has more to do with my own experience in understating businesses.
14. When it comes to bad businesses, I must know that it is a bad investment however attractive the valuation may seem. I love how Charlie Munger explains that – “a piece of turd in a bowl of raisins is still a piece of turd”…and…“there is no greater fool than yourself, and you are the easiest person to fool.”
15. I must get going on valuing good businesses…but when I find that the business is bad, I must exercise my options. Not a call or a put option, but a “No” option. 

https://www.safalniveshak.com/stock-valuation-manifesto/

How to value shares (checklist)

Here is a checklist to remind me of the process when valuing shares:

1.  Value the companies using an estimate of their cash profits.

• What is the cash yield a company is offering at the current share price?
• Is it high enough?

2.  Calculate the company's earnings power value (EPV).

• How much of a company's share price is explained by its current profits?
• How much is dependent on future profits growth? 
• If more than half of the current share price is dependent on future profits growth, do not buy these shares.

3.  What is the maximum price you will pay for a share.

• You should try and buy shares for less than this value.  
• Apply a discount of at least 15%.
• The interest rate applied to calculate the maximum price should be at least 3% more than the rate of inflation.

4.  To pay a price at or beyond the valuations above, you must be confident in the company's ability of continuing future profits growth (quality growth companies).

• The higher the price paid for profits/turnover/growth, the more risk you are taking with your investment.
• If profits stop growing, then paying an expensive price for a share can lead to substantial losses.

Additional notes:

Investing using checklists is a very powerful method.

It focuses your thinking and guides you in the investing process.

If you are to be a successful investor in shares, you need to pay particular attention to the price you for for them.

• The biggest risk you face is paying too much.
• It is important to remember that no matter how good a company is, its shares are not a buy at any price.

Paying the right price is just as important as finding a high quality and safe company.

• Overpaying for a share makes your investment less safe and exposes you to the risk of losing money.

Also, do not be too mean with the price you are prepared to pay for a share.

• Obviously you want to buy a share as cheaply as possible, but you should also realise that you usually have to pay up for quality.
• Waiting to buy quality shares for very cheap prices may mean that you end up missing out on some very good investments.
• Some shares can take years to become cheap and many never do.

The Philosophy of Value Investing and Why It Works

What is Value Investing?

The terms used to describe value investing don't require any accounting or finance background.

Value investing is described as paying 50 cents for a business worth $1. 

Warren Buffett's analogy using the maximum allowable weight of a bridge is used to illustrate how this margin of safety works:

"When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing."

Margin of Safety (buying at a discount) is of utmost importance

What allows value investors to apply a margin of safety while most speculators and investors do not?

Again using a Buffett analogy to illustrate this:

A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors have infinite patience and are willing to wait until they are thrown a pitch they can handle—an undervalued investment opportunity.

Value investors do not buy businesses they do not understand, nor ones that they find risky. For example, they will avoid technology companies and commercial banks. 

Value investors will also invest where their securities are backed by tangible assets, to protect them from downside risk.

Because the future is unknown (e.g. a business worth $1 today might be worth 75 cents or $1.25 tomorrow), there is little to be gained by paying $1 for this business.

The margin of safety (buying at a discount) is therefore of utmost importance. 

Value investors gain an advantage when many:

• do not buy with a margin of safety, 
• remain fully invested at all times, and 
• trade stocks like pieces of paper with little regard to the underlying asset values.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

The Five Rules for Successful Stock Investing 11

Valuation – Intrinsic Value

The value of a stock is equal to the present value of its future cash flows.

Companies create economic value by investing capital and generating a return. Some of that return pays operating expenses, some gets reinvested in the business, and the rest is free cash flow. We care about free cash flow because that's the amount of money that could be taken out of the business each year without harming its operations. A firm can use free cash flow to benefit shareholders in a number of ways. It can pay a dividend, which essentially converts a portion of each investor's interest in the firm to cash. It can buy back stock, which reduces the number of shares outstanding and thus increases the percentage ownership of each shareholder. Or, the firm can retain the free cash flow and reinvest it in the business.

These free cash flows are what give the firm its investment value. A present value calculation simply adjusts those future cash flows to reflect the fact that money we plan to receive in the future is worth less than the money we receive today. Why are future cash flows worth less than current ones? First, money that we receive today can be invested to generate some kind of return, whereas we can't invest future cash flows until we receive them. This is the time value of money. Second, there's a chance we may never receive those future cash flows, and we need to be compensated for that risk, called the "risk premium".

Value is determined by the amount, timing, and riskiness of a firm's future cash flows, and these are the three items you should always be thinking about when deciding how much to pay for a stock.

[...] the present value of a future cash flow in year n equals CFn/(1 + discount rate)^n.

If you really want to succeed as an investor, you should seek to buy companies at a discount to your estimate of their intrinsic value. Any valuation and any analysis is subject to error, and we can minimize the effect of these errors by buying stocks only at a significant discount to our estimated intrinsic value. This discount is called the margin of safety [...].

Putting It All Together

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

"Margin of Safety" as the Central Concept of Investment

The Intelligent Investor by Benjamin Graham

Chapter 20 - “Margin of Safety” as the Central Concept of Investment

A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.
Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

MARGIN OF SAFETY CONCEPT: STOCKS SHOULD BE BOUGHT LIKE GROCERIES, NOT LIKE PERFUME

The high CAGR in the early years of the investing period, due to buying at a discount, tended to decline and approach that of the intrinsic EPS GR of the companies over a longer investment time-frame.

Making investing enjoyable, understandable and profitable...*

Is it not true, that the really big fortunes from common stocks have been garnered by those who made a substantial commitment in the early years of a company in whose future they had great confidence and who held their original shares unwaveringly while they increased 10-fold or 100-fold or more in value?

The answer is "Yes."  

 
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BENJAMIN GRAHAM'S 113 WISE WORDS
The true investor scarcely ever is forced to sell his shares, and at all times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgement."

 
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PHILIP FISHER'S WISE WORDS
"The refusal to sell at a loss, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process.

More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous."

(Common Stocks and Uncommon Profits)

 
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Chapter 20 - “Margin of Safety” as the Central Concept of Investment

A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

 

The Perfect Moment to Buy a Stock

Hi, 

I hope you've been enjoying my newsletter so far! 

You've been a subscriber for about a month now, so I would like to take this moment to really thank you for your support! I truly appreciate it, and I'm hoping I can continue to provide you with some excellent content that you can't get anywhere else, and keep you as a loyal subscriber for even longer. 

Today I will share with you how to identify the perfect moment to buy a stock, and it's probably different from what you expect. Why? Because it has little to do with timing, and more to do with the stock price in relation to the intrinsic value of a company. Let me explain. 

"Price is what you pay, value is what you get." 

There is a crucial difference between price and value, and the above quote by Warren Buffett captures this perfectly. If you want to sell your desk chair on eBay, you can ask any price for it you like. However, the value the buyer receives in return, a desk chair, remains exactly the same, regardless of the price you decide to ask. 

It's the same with stocks. A stock price says little about how much a stock, which is essentially a tiny slice of a business, is actually worth. Investors can ask any price they like, but this doesn't change the underlying business. This means it is possible for stock prices to deviate significantly from their intrinsic value, which is great, because exploiting mispriced stocks is what value investing is all about!

So what is the perfect time to buy a stock? 

Well, you first have to determine whether you are dealing with a financially healthy company. Secondly, using conservative inputs, you need to estimate the intrinsic value of a company to determine what a stock should realistically be worth. Is the stock trading at a price way below the intrinsic value you calculated? Sweet! Then this is the perfect time to buy. If not, put it on your watch list until it is finally cheap enough to get in. 

Timing the market, or trying to predict when a stock will move up or down in the short run, is impossible. You might get lucky a few times, but this strategy is doomed to fail in the long run, since prices can be extremely volatile, highly irrational and therefore 100% unpredictable. The only sound way to determine when to buy is to look at the stock price in relation to the intrinsic value of the underlying company. 

Don't worry if the price declines further after your initial investment, because now you can buy more of a wonderful company at an even lower price! You don't have to buy at the absolute bottom. You just have to buy it for a cheap enough price to make a more than handsome return. 

Now that you know when to buy a stock, you might be interested in learning when to sell. In episode #18 of my value investing podcast I cover the only three reasons to ever sell a stock. Here is a link for you below:
https://www.valuespreadsheet.com/investing-podcasts

Cheers, and all the best to you! 

Nick