- It’s impossible to accurately determine the actual value of a stock, but there are some methods that allow you to come close.
- What’s even better is when you can buy at a price much lower than your intrinsic value calculation.
- Qualitative factors can also help in assessing the margin of safety.
The best investments are those that carry no risk with unlimited upside.
Given that the markets are inefficient, it’s possible to find such investments and in today’s article, I’m going to describe the best ways to figure out what the margin of safety is in an investment.
When an investment has a large margin of safety, the probability of permanent capital loss is minimal while the upside remains unlimited, as with all investments.
Here are 5 easy ways to determine a margin of safety.
#1: Cash Is The Easiest Way To Determine The Margin Of Safety
This might sound too easy to be true, but there are times when a company’s market capitalization is below its net cash per share. In October 2008, almost 1,000 stocks were trading at a price below cash value.
You might think such a situation to be impossible, but it isn’t that uncommon because investors don’t know what the management will do with that money and if there is enough selling pressure on the sector, a stock can easily trade at a price below net cash per share. Net cash per share is determined by deducting total debt from cash and cash equivalents.
However, not everything is that easy. If a company isn’t profitable and will burn through that cash in the future, we can’t really look at the cash as a margin of safety. Growth and biotechnology companies often have large cash balances due to capitalizations rounds which makes them seem cheap but given their cash burn rate, they aren’t.
The time to buy stocks trading below net cash value is in market downturns when pessimism surrounding the whole market creates high pressure on selling and pulls all stock prices down. A combination of sound fundamentals, a business that operates profitably, low debt, and more cash than the market capitalization is the ultimate margin of safety investment.
An example of such a company is Nevsun Resources (NYSE: NSU).
In January 2016, Nevsun is a Canadian mining company that had one cash flow positive operating mine in Eritrea and no debt alongside $460 million U.S. dollars in cash in Canadian banks.
With the number of shares being 200 million, it would be completely irrational for the stock to trade below $2.3 at any given point in time as that was the cash balance per share. Nevertheless, the share traded at exactly $2.27 on January 14, 2016 and closed the day at $2.32 when markets were extremely bearish about a slowdown in China and demand for commodities.
Needless to say, NSU’s stock quickly recovered and the short time span when it was trading below net cash per share resulted in a great buying opportunity.
Figure 1: NSU’s share price in the last two years. Source: Yahoo Finance.
NOTE: Nevsun later used most of its money to acquire Reservoir Minerals, and has paid out $0.18 cents in dividends since then. The company was plagued by bad news in Eritrea where it halved the life of its mine, didn’t manage to separate copper from the ore as expected, and had to cut the dividend. Nevertheless, those who bought when the stock was trading below cash value didn’t lose any money as they bought in with a cash margin of safety, the ultimate margin of safety.
Another example of a margin of safety is liquidation value.
In order to determine the liquidation value of a company, we must assume it isn’t a going concern anymore and can also assume the selling value of the company’s assets. By deducting total debt, we can determine the liquidation value which can often be higher than the market capitalization.
A metric that helps in determining liquidation value is book value, but not all book values can be taken at face value. The book value of a company represents the accounting value of the company.
It’s very rare to find a company that has its book value equal to its liquidation value. For example, buildings are usually depreciated in 40 years. So if a company bought a building 40 years ago, the value of that building on the balance sheet could easily be zero but if the company put the same building on sale, the value would probably be much higher than what the company paid for it four decades ago.
However, if a company acquired another company at peak economic activity and overpaid, the value on the books is determined by what the company paid, but the actual value is probably much lower. In this case, you can expect an impairment of value which will negatively impact earnings.
The main point in determining liquidation value in order to calculate a margin of safety price is to look beyond the numbers on the balance sheet and calculate the actual market value of the assets owned by the company. The good thing is that debt is usually at face value.
Concerning debt, a situation where the value investor has to be careful is when pension liabilities depend on how the company calculates them and can’t be precisely determined in advance. To increase the margin of safety, it’s perhaps better to stay away of companies with large or potentially large pension liabilities.
Determining Intrinsic Value
Intrinsic value goes one step further and is a bit more complicated than the above two methodologies, but is the most used by the likes of Buffett and Klarman. Read more in our detailed article about calculating intrinsic value.
Looking At Qualitative Factors
You might be surprised that I’ve discussed qualitative factors in determining a margin of safety, but the current investing environment is much different than it was in the 1930s when the strategy was formed by Benjamin Graham.
A margin of safety can be found in the number of users of a new technology, market share, competitive advantages, brand strength, management competence and focus, geographical positions, legal jurisdictions, etc. However, don’t be fooled by qualitative factors as at the end of the line, the final answer is given by the cash the company produces, nothing else.
It All Boils Down To The Price You Pay
The main factor in determining the margin of safety is the price you pay. If you overpay for a stock, the margin of safety will probably be non-existent. At a lower price, it could be small while at an even lower price, it could be large. Therefore, the best thing to do is to invest only in stocks that offer large margins of safety.
Given that it’s impossible to accurately determine the intrinsic value of a stock, the best thing to do is to buy with a large margin of safety in order to allow for human error. Buffett’s favorite way of describing this is by using his truck and bridge example: “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing.”
Figure 2: Buffett’s truck margin of safety example. Source: Graham and Doddsville.