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).
Margin of Safety Calculation
Although the concept of Margin of Safety is pretty straightforward, the application of a Margin of Safety analysis in practice can be a tricky endeavour. Although the name implies that the analysis will render a specific number or a percentage discount, that number will never be exact.
In order to estimate the margin of safety of a company or a security, requires the analyst to have an opinion of the security’s Intrinsic Value. That opinion requires the analyst to make assumptions about the future and to assess the company from a qualitative standpoint. The lower the current market price is versus the intrinsic value, the bigger the margin of safety should be for the investor.
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.
Seth Klarman and Margin of Safety, the Book
In 1991, Seth Klarman, a principal investment manager of Baupost Capital, published a 250-page book called Margin of Safety, Risk-Averse Value Investing Strategies for the Thoughtful Investor. Klarman’s book aims to build on the Value Investing principles laid forward by Ben Graham in both Security Analysis and the Intelligent Investor.