How to use a Margin of Safety when Investing

A fundamental part of value investing is to ensure that there is a margin of safety with your investments.

What this means is that you buy a stock when its price is not only lower than or equal to your calculated fair price, but that it’s significantly lower. This provides you with some gray area where your assumptions about the company can be a little bit off, and yet the investment will still turn out okay over the long run.

The margin of safety means that your assumptions would have to be significantly off course for that investment not to work out. But even then, by diversifying across 20+ companies and into other asset classes, the scenario becomes statistical in nature. For example, if you invest in 20 companies, and you only invest when a stock is trading at least 15% below your calculated fair price, then one or two of them can go bad while your overall portfolio will still perform admirably.

In the example of this chart, the time to buy would be when the stock price (red line) falls below the intrinsic fair value (blue line). It’s easier said than done, because you won’t have the benefit of seeing the rest of the chart in front of you, and the intrinsic fair value (blue line) is your calculated estimate of what the stock is worth rather than an absolute truth.

By sticking to sound value investing principles, however, you can do well. As can be seen in the chart, the fair value of a healthy company will be far less volatile than the stock price can potentially be, with only minor adjustments occurring each year based on new information.

How to Calculate Intrinsic Value

In order to buy at an undervalued price, you’d first have to know what the fair price is. This combines art and science. The science is that given perfect company estimates and your target rate of return, you can easily calculate the objective fair value of any business or asset that produces cash flow. The art is that of course you don’t have the perfect estimates, you only have your imperfect approximations. You can make estimates based on historical growth rates, or based on future trends that could shape those growth rates, based on analysis of how the company is spending its cash, or based on realistic management projections and a pattern of meeting those projections.

Discounted Cash Flow Analysis (DCFA) is the fundamental stock valuation methodfor any asset or business that produces cash flows. When this method is applied on a share-by-share basis of a dividend stock, then it’s called either the Dividend Discount Model or Method (generally), or the Gordon Growth Model (under expectations of a perpetual static growth rate).

DCFA and the associated DDM produce perfect fair values given perfect inputs, although of course you’re always going to have imperfect inputs. And the longer the actual stock price remains under the calculated fair value, the better it is for an investor assuming that you’re reinvesting dividends, buying more shares, or the company is repurchasing its own shares.

How Big of a Margin of Safety is Sufficient?

The size of the margin of safety will vary based on investor preference and the type of investing that she or he does.

“Deep Value Investing” refers to buying stock in seriously undervalued businesses. The goal is to find significant mismatches between the current stock prices and the intrinsic value of those stocks. Due to the degree of difference, these companies are often either small, or in bad shape. If they were well known and in good shape, then there would hardly ever be a serious mismatch of value and price except possibly for major macroeconomic deterioration such as during the local market bottom of early 2009. So deep value investing requires guts. You’ve got to pick through the rubble and find value where others aren’t seeing it. You have to see information that others are not seeing, or you have to interpret and act on information that others have, but are misinterpreting or failing to act on. Needless to say, deep value investing requires a considerably large margin of safety to invest with and isn’t for most casual investors.

“Growth at a Reasonable Price (GARP) Investing” refers to a more balanced approach. With this investing method, you pick companies that have positive growth rates that are also trading somewhat below your intrinsic fair value calculation. Dividend Growth Investing falls closer to GARP investing than deep value investing, because dividend growth investing relies on selecting companies with wide moats, strong balance sheets, the ability to grow dividends through recessions, and a product or service that you can see existing and indeed flourishing 10 or 20 years from now. With GARP investing or Dividend Growth Investing, it’s important to have at least a 10% margin of safety, but it’s not very often that you’re going to find enormous differences between price and value which allows you to buy with a huge margin of safety. They’re more stable and less contrarian selections. So rather than investing with access to better information or interpretations than others, you’re merely investing with a different time horizon. While others may be fretting about a quarterly report or something Congress did or a jobs report, you’re focusing on your passive income goals a 5-10 years from now.

How to Find Undervalued Stocks

Earlier this year I published the Dividend Toolkit for readers, which along with a comprehensive investing guide, includes the spreadsheet that I developed for myself to use to calculate the fair price of stocks.

If you want to calculate the fair value of a stock using the Dividend Discount Model (which is explained in significantly more detail in the book), and you estimate that the dividend will grow by 5% per year, and you’re using 12% as your discount rate. First, you put the simple inputs into the Dividend Discount Model spreadsheet tool:

And the tool instantly updates the output chart to tell you the fair value of the stock:

This output chart will not only tell you the fair stock value based on those inputs, but will also tell you the fair stock value based on nearby inputs. In this example, in addition to calculating the results for 5% dividend growth and a 12% discount rate, it will automatically show what the fair value is if it turns out that the stock only grows its dividend by 4%, or if you use a discount rate of 11% instead.

There are four different tools in the spreadsheet tool, including DCFA and DDM models. All of them focus on showing what kind of margin of safety you have based on your inputs, and the static-growth models also show what kind of rate of return you can expect given certain growth outcomes.

Besides the Toolkit, there are other ways to calculate fair price as well. You can do the simplest versions with a calculator or with free online tools. You can develop your own model if you have the time and desire.

A Margin of Safety BOOSTS Returns Rather than Just Providing Protection

Value investing or dividend investing may often be thought of as conservative investing methods, and this may be true in many cases. But the purpose of a margin of safety is not just to protect your rate of return, but indeed to improve it.

When you buy a stock below calculated fair value, an expectation is that in some future time, the stock price will go back up to fair value in a rational market. If your growth expectations end up being correct, and you bought at an undervalued price, then you should eventually get a superior rate of return.

Alternatively, the longer the stock remains undervalued, the better it is for shareholders, because their reinvested dividends, or their new purchases, or management’s share buybacks, continue to accumulate undervalued shares. It actually becomes a demonstrably negative scenario for a long term investor when their stocks go up above fair value.

Buffett put it concisely in his 2011 shareholder letter:

Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won’t keep you in suspense. We should wish for IBM’s stock price tolanguish throughout the five years.

Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1.5 billion more than if the “high-price” repurchase scenario had taken place.

The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.

Source: Berkshire Hathaway Shareholder Letter, Warren E. Buffett

That’s how Buffett made 30-50% returns in his early days. He wasn’t investing in companies that were growing earnings by 30-50% per year; he was investing in companies that were seriously undervalued. Eventually, those stocks will return to normal values, and the longer they don’t, the better it is for the investor.

(Note: Rather than picking large caps like IBM, he was a deep value investor, finding huge mismatches between price and value. As his base of capital grew, it was no longer economical for him to invest in small companies and he either had to buy whole companies or invest primarily in large caps that either have GARP or dividend growth characteristics.)

Margin of Safety Example:
Here’s an example of how an undervalued stock selection can offer outsized returns.

Suppose you use the Toolkit Spreadsheet or some other Dividend Discount Model tool to determine the fair price of a stock. Let’s use the above example, where it was calculated that a company paying $1.80 in dividends per share this year and growing that dividend by an average of 5% per year into the future, with a discount rate of 12%, is worth $27/share.

What this means is that if the company performs as expected, then buying at $27 should give you long-term returns of around 12% per year. Now, in any given year, the stock may go up or go down; it could fluctuate wildly around that fair value. And of course you’ve got to occasionally adjust your fair value assessment to take into account new information (like how this site re-analyzes the companies I cover on an annual basis). But over the long run, earnings determines price.

For example, let’s say that the stock that pays $1.80 in dividends per share (DPS) this year has $2.50 in earnings per share (EPS) this year. If you pay $27/share for the stock, then you’re paying a price-to-earnings ratio (P/E) of 10.8, and the stock has a dividend yield of 6.67%.

Ten years from now, if it grew earnings and the dividend by 5% per year as expected, then their dividends per share are now $2.93 and the EPS is up to $4.07. This is their fundamental performance, but let’s see two different buying scenarios.

Scenario A: Buy at Fair Value
In this scenario, the investor buys 100 shares at $27, for a total investment of $2,700 and a total dividend income stream of $180/year. If the company grows EPS and the dividend by 5% per year for the next ten years as expected, and if the investor reinvests her dividends each year, then by the end of the 10 year period if the stock remains at fair value for this whole time, she’ll have over 190 shares at a price of nearly $44 each, and so her total investment will be worth $8,385 and her annual dividend income will be $559.

Now, that’s an increase in wealth from $2,700 to $8,385 over a 10 year period, which translates into a 12% annualized rate of return. (The rate of return matched the discount rate that was used to calculate fair value in the first place.) Dividend income rose from $180 to $559, which is also a 12% growth rate (which includes the natural dividend growth and the accumulation of more shares due to dividend reinvestment.)

Scenario B: Buy at 15% Discount to Fair Value
In this scenario, the fundamentals of the stock are identical. The initial EPS and DPS, and their growth rates through the 10 year period are identical to scenario A.

But this time, the market is depressed, and the investor buys shares at a 15% discount to her calculated fair value of $27, which means she buys the shares at $22.95. She can buy 100 shares for $2,295, and will have the same $180 annual dividend stream to reinvest.

Over this ten year period, let’s say the price of the stock gradually increases back up to fair value as the market sees this company continue to perform well. So in the starting period, it’s at a 15% discount, then later only 10%, 5%, and eventually is at fair value. So the price increases from $22.95 to $44. Because shares were cheaper on average over this period but her dividends were the same, she was able to accumulate more shares. By the end, she has around 200 shares at nearly $44 each, for total wealth of $8,768. Her annual dividend income is $584.

So, her investment increased from $2,295 to $8,768 over 10 years, which translates into a 14.3% annualized rate of return. (If she had bought $2,700 worth of shares initially, she could have bought more than 100, and she’d be up to $9,650 or so in wealth.) Her dividend income stream increased from $180 to $584, which is a 12.5% annualized rate of return, and it took significantly less capital to acquire the same income stream (she could have used the initial $2,700 to buy more.)

Same company, same performance, and yet buying at a 15% discount to fair value meant 14.3% annualized returns instead of 12% annualized returns. This means more money in the end, and larger income streams.

Conclusion

As a recap, the purpose of buying with a margin of safety is twofold:

1) It makes your portfolio more conservative because your growth estimates could be a little bit off and the investment will still work out.

2) If your estimates are correct, then your rate of return will be superior over time because the growth rate of the investment is augmented by the additional fact that you bought it at an undervalued price. Over the longest term, your results will be superior either because the market eventually returns the price to its fair value, or because for as long as its under its fair value, your reinvested dividends or the company’s share repurchases will be able to buy more shares for the same amount of money.

To calculate intrinsic fair value, the fundamental way is to use a version of Discounted Cash Flow Analysis, either on the company as a whole or on a share of a dividend paying company. When it’s done in the second way it’s called the Dividend Discount Model. The inputs you’ll need are the current free cash flow or dividend, the estimated growth of that free cash flow or dividend, and a discount rate, which is equal to your target rate of return for practical purposes. When DCFA is understood, then there are shortcuts that allow for reasonable valuation such as basing estimates on P/E, the PEG ratio, or shareholder yield, etc.

http://dividendmonk.com/margin-of-safety/