Businessman Investor

Touching base with the rational business psyche of stock market investors

Tuesday, September 20, 2011

The Quantitative Principle of the Margin of Safety

Margin of Safety as a Percentage Discount. Say the intrinsic value estimate is Php100, a 50% margin of safety would net Php50, the safe price to buy the stock.
This is Part 1 of a Series.

I’ve been blabbering about capital preservation and rational potency of earnings lately. And while watching a Value Investing Conference 2008 video of Alice Schroeder (author of The Snowball: Warren Buffett and the Business of Life) talking about Buffett’s simple thought process in investing, I was particularly struck when she said: “The purpose of the margin of safety is to render forecast unnecessary.” It was a golden nutshell statement which succeeded elegantly in trying to communicate what I intended to point out when I wrote somewhat extensively about capital preservation and rational potency of earnings.

She described that most analysts would rely on a model that would forecast future cash flows then discount them at an appropriate rate. Surprisingly, Schroeder points out that Warren never bothered with financial models. What?! His thought process puts great emphasis, instead, on analyzing historical data in great detail (i.e. sales, expenses, profits in each plant, quarter-by-quarter) then he’d have this generic required rate of return of 15%, and glean whether the business is capable of achieving it or not. He compares—they earned this much, I want this much... Can they do it? Yes/No. It was a very simple decision.

Simply, the emphasis is margin of safety. What is margin of safety? Some would view it as a percentage discount applied to an estimated intrinsic value to provide an allowance for error. Say, the estimate is at Php100, a 50% margin of safety would net Php50—the safe price to buy the stock. It’s a very quantitative interpretation and application. Continue to Part 2: The Margin of Safety Mentality—A Cornerstone of Value Investing


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