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Tea with Matthew Seah: Margin of safety.

Friday, June 9, 2017

Matthew shares with us a simple and important concept to invest more safely:

The intrinsic value of a company could be calculated base on our estimations of various aspects of the business, both tangible and intangible. Hence one would require to look at both qualitative and quantitative aspects of the business in order to give a more holistic valuation of a company.

Company valuation can be done using 2 broad types of valuation models:
- absolute valuation; and
- relative valuation.

Absolute valuation is a valuation method that give you an absolute value to compare against the current market price. Absolute valuation method is broadly termed as a discounted “cash flow” method. The different models calculates future cash flows -- dividend (Discounted Dividend Model), free cash flow (Discounted Free Cash Flow Model), operating cash flow (Discounted Operating Cash Flow Model), residual income (Discounted Residual Income Model), etc -- and discount these future values to present value.

Relative valuation is a valuation method that compares certain metrics -- price to earnings ratio (P/E), price to book ratio (P/B), price to sales ratio (PSR), total enterprise value to earnings before interest, tax, depreciation and amortisation (TEV/EBITDA), etc -- against the industry or market average.

Each of these valuation models, including those not mentioned, have their pros and cons. 

Do note that even with complete knowledge of the business, company valuation is still an estimation of what the value of the organisation as other external factors such as macro trends and policy changes in the future is difficult to predict.

So how to overcome this miscalculation?

Introducing Margin of Safety. 

The concept of margin of safety originated from Benjamin Graham and he wrote about it in the very last chapter of The Intelligent Investor (Chapter 20: “Margin of Safety” as the Central Concept of Investment).

Simply put, when market price is below your estimation of the intrinsic value, the difference is the margin of safety. The lower the market price of the stock, the more undervalued it is, and the greater the margin of safety. In essence, the risk of losing money is lower when buying an undervalued company with a large margin of safety.

“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” 
- Seth Klarman

Margin of safety doesn't guarantee a successful investment, but it does provide room for error in an our judgment when calculating the value of a company.

Related post:
3 points to note in investing.


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