A Margin of Safety is the difference between the intrinsic value of a security and it’s market value. In some cases, a quantitative analysis of a security will indicate a false margin of safety. The falseness can go in both directions (under- and overestimates).
Analysing Free Cash Flow Yields
If a company is trading at a low cash flow yield (price to last book year’s free cash flow):
- Free cash flow is expected to grow and the market has priced it already
- The company’s operations are capital intensive with high barriers of entry (such as utilities)
If a company is trading at a high cash flow yield:
- The company doesn’t pay dividends and has a bad reputation of reinvesting excess cash
- The company is expected to have lost earnings power
Analysing Net Asset Values
If a security is trading under Net-Net Current Asset Value:
- The company is expected to take on a big loss in the future
- The company has off-balance sheet liabilities
If a security is trading well over book value:
- The company’s operations require little capital. High return on equity.
More on Fundamental Finance
- What are Mental Models?
- A Brief History of Value Investing
- Martin Whitman on Value Investing vs. Fundamental Finance