Margin of safety
We just finished going through the most commonly used stock evaluation methods. Now, let’s proceed to review how the best known investors use them.
Let’s start with the “grandfather of value investing” himself, Benjamin Graham. He wrote the book, “The Intelligent Investor,” a book acclaimed to be “the most widely recognized investment book in the world.” (He wrote another book, “Security Analysis,” co-authored with David Dodd.) Paramount to Graham about the market is that “nobody ever knows what the market will do.” This includes analysts and stockbrokers like me. But while nobody knows what the market will do, you can still profit from it by “reacting intelligently” to what it does, according to Graham.
To do this, Graham advised that we have to “automate” part of our investment strategy. This is to “counteract our inherent emotional weakness,” he added. What he actually meant with the word “automate” is that we must “use a set of measurements that are not subject to emotion.” This is by the “use of measurable criteria” like cash flow, earnings per share (EPS), price/earnings ratio or P/E multiple, book value, price/book ratio, price/sales ratio or PSR, among others, as we have learned in fundamental analysis.
These factors, in Graham’s mind, “give us something (concrete and) stable to fall back on when we get confused by bold headlines and great stories.”
Margin of safety
Graham’s unique contribution to value investing was his concept of a “margin of safety.” Every stock, according to him, has both a “business valuation and market valuation.” The business valuation of a stock refers to the stock’s book value and its earnings. This takes into account not only what it could sell for when sold or liquidated right now (official formula of book value is net common stockholder’s equity divided by outstanding number of shares) but it also includes what potential profit it holds (net income).
Thus, business valuation refers to the combined sum of a company’s book value and potential earnings; again, earnings per share is total net income divided by outstanding number of shares. A stock’s market valuation, on the other hand, is simply the stock’s current traded price in the stock exchange. It can be lower or higher than a stock’s business valuation.
To uncover a stock’s margin of safety, he suggests that you concentrate on measures that show a stock’s value along its price/book and P/E ratio. He also suggests that you further look on measures that show a stock’s growth potential like “financial position and condition together with earnings growth.”
Notice that—like what Glen Arnold said in his book, “Value Investing: How to Become A Disciplined Investor” (a book on what he calls “Valuegrowth Investing”)—Graham was blending value and growth measures. As pointed out early in our series of evaluating stocks, value and growth investing styles are akin to north and south, a continuum.
A stock to be a good buy need not be always with a big margin of safety. It can have a small margin of safety but still be considered a good investment. We can find a lot of this kind of stocks among the blue chips (highly capitalized and financially sound companies). Graham also does not consider a stock to have a good margin of safety if you’re paying a lot more than its book value “and a lot more than what it’s earning just because the papers say the new team of people taking over are brilliant.” As observed, “if those brilliant folks make a mistake, your losses could be extreme.”
The best stock with a good margin of safety for Graham is a stock whose company operations continue to have solid financials “even when the brilliant managers mess up.” In this case, the company has underlying value not entirely depended on management’s brilliance. What could weaken a company’s margin of safety is its financial situation. A company with a high long-term debt will almost certainly lose its comparative margin of safety. Debts affect a company’s business valuation, it reduces its net worth (assets minus liabilities). This becomes worse when management commits mistakes that would reduce the company’s earnings furthermore.
It is observed that “Graham was deliberately vague in describing a stock’s margin of safety.” However, he was very firm on the premise that you “buy stocks at prices below their business valuation.” The basis of this principle is that you’re “paying less for a company than when it is sold piece by piece.” In his words, “there’s good margin of safety there.”
Graham, however, is not without some hard figure with margin of safety. He advises that you should “buy a stock for no more than two-thirds of its book value.” This meant that a stock’s price/book ratio should be no more than 0.66. For instance, if a company has a book value of P50 a share, you should pay no more than P33 for it (50 x 0.66). And, even at that low price, Graham wanted to see an accompanying low P/E ratio in the company’s earnings picture.
In the end, Graham’s margin of safety is still “a general feel” on how much a stock’s price can drop and still be a good investment. This requires a good grasp on the difference between a company’s business valuation and market valuation.
(The writer is a licensed stockbroker of Eagle Equities Inc.. You may reach the Market Rider at [email protected] , [email protected] or at www.kapitaltek.com)
