Thoughts on Margin of Safety

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

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