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Stock Investing: Margin of Safety

We are only human and humans do make mistakes. The underlying assumptions used to estimate the value of the stock could be too optimistic, projected earnings and expansion might not materialize due to economic, environmental, technological or legal constraints.

It is important to build a margin of safety when estimating the value of a company or stock. The margin of safety will act as a cushion to mitigate your investment losses if the real worth is less than your estimated value.

A margin of safety is the difference between the market price of a stock and your estimated value of a stock.

Build a larger margin of safety if you are valuing a shakier company or if there is uncertainty about its future earnings. Build a lower margin of safety if you are valuing a solid company with predictable future earnings.

Example 1: Margin of Safety

Stock W is currently trading at $23.00. Company W is a relatively new player in the industry and there is much uncertainty surrounding its future earnings. You analyzed the present value of the future cashflows of Company W. The present value is $24.00. You will want a larger safety margin for Stock W, say 35%.

Workings:
$24.00 x (100% - 35%) = $24 x 65% = $15.60

So, the right time to buy Stock W is when the stock is trading at $15.60.

Stock X is currently trading at $40.00. Company X is an established company in the industry. Its future earnings are predictable. You analyzed the present value of the future cashflows of Company X. The present value is $45.00. You want a smaller safety margin for Stock X, say 20%.

Workings:
$45.00 x (100% - 20%) = $45 x 80% = $36.00

The right time to buy Stock X is when the stock is trading at $36.00.

Example 2: Margin of Safety

Stock Y, a small company with uncertain future earnings, is trading at 18 times over its earnings. The P/E ratio is 18. Stock Z, a solid company with predictable earnings, is trading 21 times over its earnings. The P/E ratio is 21. The industry P/E ratio is 19.

For Stock Y, you will want to have a larger margin of safety since it is a shakier firm with uncertain future earnings. Assume your estimated value of this stock is P/E 17. You want a 40% safety margin.

Workings:
17 x (100% - 40%) = 17 x 60% = 10

Therefore, you will only want to buy Stock Y if the stock is trading at a P/E of 10.

For Stock Z, you will want to have a smaller margin of safety since it is a solid company and its future earnings are predictable. Assume your estimated value of this stock is P/E 20. You want a 20% safety margin.

Workings:
20 x (100% - 20%) = 20 x 80% = 16

Therefore, you will only want to buy Stock Z if the stock is trading at a P/E of 16.

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