Margin of Safety
(It is the best way to reduce the risk)
Three Important words in Investing are "Margin of Safety". Capital preservation is the first rule in investing. Why everybody thinks we don't lose money in the stock market, in other words, we think everybody in the stock market wants to need to have good protection on their investments.
So we first understand the concept of margin of safety. The margin of safety is the core principle of Benjamin Graham the father of value investors. The future value of any investment is a function of its present price. The investment return is based on what we pay for that security. if we pay a higher price then we will get a lower return. No matter how careful we are, the one risk no investor can ever eliminate is the risk of being wrong. We can use the concept of "Margin of safety" which means never paying the overpaying price of security.
The margin of safety always depends on the price paid and the best way to reduce our risk. This will help protect us from our downside. We should buy a stock with a large margin of safety if it requires a large discount rate. Always remember you should buy a stock if the margin of safety is high.
Intrinsic value and the Margin of Safety
Intrinsic value is the value that is calculated for every individual based on the estimation of the projected growth of the company. It can be calculated using different valuation approaches such as the discounted earning model, discounted cash flow, and discounted dividend model. The margin of safety provides better protection against wrong assumptions which are used when calculating the intrinsic value of the company.
Margin of Safety = (Intrinsic value – share price * 100%)/intrinsic
value
=
(1.0-0.50*100)/1 = (0.50*100%) = 50%
|
Margin of Safety |
Valuation |
|
> 50% |
Undervalued |
|
50%-
0% |
Slightly Undervalued – Fair Value |
|
>-10%
|
Fair Value – Over Valued |
|
>-50% |
Grossly Overvalued |
The best
time to buy a great margin of safety is when the market is depressed or when a
company is heavily punished by the market due to bad news. Ben Graham said the market is there to serve us and not to guide us.
The price
valuation should only be used to determine when investors want to enter or exit
stock market. It should not be used to determine the quality of the stock. The
price is mainly based on the market sentiments and not the quality of the
stock. Remember always,in essence, a margin of safety exits when securities are selling for every reason at less than their real value
Disclaimer: This blog is exclusively for educational purposes and does not provide any advice/tips on Investment or recommend buying and selling any stock
