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An Investment Management Company
Tutorial - Margin of Safety
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You've done all kinds of research, you have your list of stocks with Economic Moats,
and you're literally quivering with excitement to plunk your money down and be a wise
investor! (OK, so I exaggerated and you're not really quivering.) Now what?
Keep that list of stocks handy and wait for the right price. Buy low and sell high, right?
So how do you know when the price of a stock is low? Well, you're going to have to do
some math. What you need to do is to compute the Intrinsic Value of the stock. This
is not unlike doing an appraisal on a home. For stocks, though, we produce pro-forma
financial statements for many years in the future using "educated guesses" on the
anticipated revenues, expenses and capital costs of the business. We then use a little
calculus to discount those cash flows back to a Present Value. This gives us an
Intrinsic Value for the stock.
Having an Intrinsic Value for a stock is a wonderful thing! This is how much that stock
is really worth. The Intrinsic Value is what the stock should be selling for on the open
market -- without the emotions of fear and greed.
So, you have your Intrinsic Value for a stock. Is the market price above or below that
price? If the market price is above the Intrinsic Value you have computed don't buy
it! You'll be paying too much for the stock! The emotion of greed has gathered all the
investing lemmings to this stock and that's not where you want to be when it comes time
to buy the stock.
What you're looking for is the stock of a company that has a solid Economic Moat and
is trading below its Intrinsic Value. The further below Intrinsic Value you buy the
stock, the greater your Margin of Safety. You need a Margin of Safety because our
"educated guesses" used to compute the Intrinsic Value are not going to be right all
the time. So, once again as conservative, prudent investors, we look for ways to lower
our risk. The greater our Margin of Safety, the lower our risk of losing money on this
investment.
Why might a company with a solid Economic Moat be selling below its Intrinsic
Value?
Obviously we must use great judgment and lots of courage to buy these stocks when
they have a substantial Margin of Safety (and the lemmings are running from them in
fear). Our faith in the Intrinsic Value of the stock helps us make these tough
decisions without being effected by the emotion of the marketplace.
Management Integrity. One additional factor we use to ensure our Intrinsic Value
is accurate is by looking at the integrity of management at the company. Do they
manipulate inventory to "manufacture" revenues that will be well received by Wall
Street? Do they have a vested interest in the value of the stock over the long-haul?
Have they demonstrated they have the investors' best interests at heart? There are
many things to look at to ensure managers are good stewards. This is critical to
making sure the numbers you are relying upon from them to compute your Intrinsic
Value are accurate.
So, you've found your perfect company at a discount price. How exactly is this going to
make you money? To learn about Making Money, Click Here.
and you're literally quivering with excitement to plunk your money down and be a wise
investor! (OK, so I exaggerated and you're not really quivering.) Now what?
Keep that list of stocks handy and wait for the right price. Buy low and sell high, right?
So how do you know when the price of a stock is low? Well, you're going to have to do
some math. What you need to do is to compute the Intrinsic Value of the stock. This
is not unlike doing an appraisal on a home. For stocks, though, we produce pro-forma
financial statements for many years in the future using "educated guesses" on the
anticipated revenues, expenses and capital costs of the business. We then use a little
calculus to discount those cash flows back to a Present Value. This gives us an
Intrinsic Value for the stock.
Having an Intrinsic Value for a stock is a wonderful thing! This is how much that stock
is really worth. The Intrinsic Value is what the stock should be selling for on the open
market -- without the emotions of fear and greed.
So, you have your Intrinsic Value for a stock. Is the market price above or below that
price? If the market price is above the Intrinsic Value you have computed don't buy
it! You'll be paying too much for the stock! The emotion of greed has gathered all the
investing lemmings to this stock and that's not where you want to be when it comes time
to buy the stock.
What you're looking for is the stock of a company that has a solid Economic Moat and
is trading below its Intrinsic Value. The further below Intrinsic Value you buy the
stock, the greater your Margin of Safety. You need a Margin of Safety because our
"educated guesses" used to compute the Intrinsic Value are not going to be right all
the time. So, once again as conservative, prudent investors, we look for ways to lower
our risk. The greater our Margin of Safety, the lower our risk of losing money on this
investment.
Why might a company with a solid Economic Moat be selling below its Intrinsic
Value?
- Often somebody does something stupid at the company that scares investors
away (fear). Has this event damaged the Economic Moat? If not, you've got
yourself a great company on sale. Buy it! - Sometimes another company in the industry runs into some type of problem.
This usually causes the investing lemmings to not only run in fear from that
company, but they run in fear from the entire industry. Has the event damaged
the Economic Moat of your company? If not, buy it! - The typical business with a solid Economic Moat is usually quite boring.
Investors lose interest in these stocks and wander away from them from time to
time. If the lemmings have wandered away through boredom, buy it!
Obviously we must use great judgment and lots of courage to buy these stocks when
they have a substantial Margin of Safety (and the lemmings are running from them in
fear). Our faith in the Intrinsic Value of the stock helps us make these tough
decisions without being effected by the emotion of the marketplace.
Management Integrity. One additional factor we use to ensure our Intrinsic Value
is accurate is by looking at the integrity of management at the company. Do they
manipulate inventory to "manufacture" revenues that will be well received by Wall
Street? Do they have a vested interest in the value of the stock over the long-haul?
Have they demonstrated they have the investors' best interests at heart? There are
many things to look at to ensure managers are good stewards. This is critical to
making sure the numbers you are relying upon from them to compute your Intrinsic
Value are accurate.
So, you've found your perfect company at a discount price. How exactly is this going to
make you money? To learn about Making Money, Click Here.
| Investing Wisely |
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| The advice contained within this website is general in nature, only for the use of FI Investments clients, and should not be relied upon without first consulting with FI Investments. |