Margin of Safety

By Erick A. Rubin on Friday, March 15, 2019

Summary

Margin of safety is defined as ‘attractive buying price’ as extracted and perceived from the estimated real value of the company. In other words, as a rule of thumb, the idea following MOS is to buy $1 of value for 50 cents.    

‘Price is what you pay, value is what you get’ -Warren Buffet

From the famous quote of the legendary investor Warren Buffet, we learn instantly that price and value are not the same, this is possible because sometimes the value of the business we want to buy is not equal to the price it’s selling for. 

How can we identify the real value of a company?

In order to have the correct MOS and buy the company at an attractive price, we must know first the company’s actual market value. To summarize, we have the ability to estimate the company real value in several ways such as: owner earnings, future cash flow stream, capitalize todays, DCF (dividend cash flow), FCFF (free cash flow to the firm), FCFE (free cash flow to the equity) and many other variations which require another full essay on its own.   

Why do we need MOS in our investment buying?

As an investor, it’s critical to understand that we must know what a business is worth (real value), once we understand the business’ real value, we wish to insure our investment by buying the exact same business for the minimum of attractive buying price of 50% to the company real value. By doing so, we are basically protecting our downsize investment and look up to the market to balance its value perception towards the specific company and drive its price up. Keep in mind that the single most important determinant of the money we gain in the future is the price we pay today.  

How much MOS should we observe?

The amount of MOS which we should observe before buying a business should be a minimum of attractive buying price of 50% below to the it’s real value, so we will expect to gain from that point of investing onwards. Take note that the lower the price we will buy the business, the higher returns we should expect as long as the real value estimations is as accurate as possible.

Would a company price ever reach our MOS price?

First of all, it is very important to note that the price of a stock in the public market is determined upon the transactions of buying or selling and its money volume on the stock traded at the open market place. The market place is a representative of all of us together; active private investors, large mutual funds, investment companies, banks etc. The market place being bipolar goes through gigantic mood swings from the highest euphoria to the lowest depression. Personally, I prefer to buy from the market place when it’s severely depressed and at this point of time, sometimes we find a huge price drop in selling prices and it provides us with the opportunity to achieve our buying goal which is to buy the business we really want within its margin of safety to its real value.    

Case study on margin of safety 

A case study which the market place was severely depressed and selling companies on sale is at the year 2000 when the internet bubble market crushed. A specific company 2000 Apollo (APOL) was on sale. The company fundamentals were consistent and looking great. Sales growing at 35%; EPS growing at 35%; equity growing at 36%; cash growing at 30%; ROIC 18%. Historical growth 35%. Analysts estimating 25%. Assuming the analysts were correct, the real value conservatively at $40. The market place was so depressed that it couldn’t believe its own analysts and selling the stock at sale price of $10! By May 2005 the same market place price the stock for $79. Five-year compounded return is 52% per year.

Disadvantage of margin of safety 

The main disadvantage of the margin of safety is the fact that the market place does not get into a depressing mode very often and we as investors are not exposed to a real market opportunity of buying within the MOS and therefore, we lose a potential investment of buying on the market place a lot. An actual example for that that we can observe was the last market place melt down on the subprime crisis on 2009. More than a decade ago, the market place has been rapidly going upwards and have only few price corrections which in retrospect were great entering points for buying great business in reasonably great prices. In other words, by waiting for the specific MOS price we might lose the right opportunity to buy a great business.       

Conclusion 

The secret to making a great rate of return on our business buying is to make sure we are getting a minimum of $1 of value for only 50 cents. First, we determine the real value as our anchor and extract the margin of safety we need to protect and improve our buying decision.