Don’t get discouraged because you feel it’s difficult to determine the intrinsic value of a stock. It is not a science! Any calculations that involve the future are subject to a wide margin of error. There are too many variables and possible end results for anyone to be expected to make precise calculations of intrinsic value.
In fact it is those variables that make up your estimated intrinsic value that are more important than an exact intrinsic value number. So don’t get too fixated on an exact number. The best analysts will have a clear understanding of the variables. It is the variables that determine your required margin of safety.
“You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. but you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And the same principle works in investing.”
Warren Buffett
The Relationship with Margin of Safety
“The secret to investing is to figure out the value of something – and then pay a lot less.”
Joel Greenblatt
The required margin of safety is the amount of discount (below the intrinsic value) an investor desires in order to purchase the asset. A value investor searches for assets with the greatest margin of safety. That means finding assets with a market price far below the investor’s perceived intrinsic value.
Here is the important concept: After determining a reasonable range for intrinsic value, require a sufficient margin of safety to allow for unforeseen problems and/or your mistakes. In other words, the wider the range of your estimated intrinsic value then the larger your required margin of safety.
High uncertainty in intrinsic value combined with a small margin of safety equals high risk. Low uncertainty combined with a large margin of safety equals low risk.
It’s helpful to approach risk a little differently. Think about searching for investments in which the perceived risk is greater than the real risk. Usually this means the price is lower than the real value. You would want to avoid investments where the perceived risk is less than the real risk. In this case the stock would probably be overpriced.
Ultimately low risk means having a sufficient margin of safety! The best risk/reward ratio investments are found by purchasing assets at prices far below their intrinsic value. In other words, finding mis-priced securities is the best approach to lowering risk and increasing returns.