The Margin of safety: Consider these during Stocks Purchase!

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  • By BYSOS Expert
  • July 30, 2021

People who know about value investing will be familiar with the term called “margin of safety”. Generally, people prefer to apply a rule of thumb when it comes to the margin of safety. A stock trading at two-third of its estimated intrinsic value can be said to be available at a good margin of safety.

However, Quality stocks always trade at overvalued price levels. Even if their price corrects, they never come even close to my estimated intrinsic value. So expecting them to trade at a two-third level is impractical.

Why Margin of Safety is Essential?

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Estimating the intrinsic value of stocks is like interpreting a holy book. Everyone who reads the book can interpret it differently. We can say, intrinsic value estimation is a similar process. There are no formulas. It is done based on logic, assumptions, and interpretation of numbers.

Hence, for the same stock, if there are ten analysts, it might give way to ten different intrinsic value numbers. It is also a fact that, out of the ten, some will be wrong, and some will be close to accurate. It is understandable, right? Like our mathematical problems.

But the problem with intrinsic value is that, because it can only be estimated based on assumptions, even for the best of investors, the end number can be wrong. How to account for this miss?

This is where the concept of margin of safety comes in handy. Suppose a stock is trading at a market price of Rs.110 per share. You have estimated its intrinsic value as Rs.115. It means the stock is trading at a 4.3% discount on its intrinsic value.

On the face of it, the stock looks like an immediate buy (undervalued). But… Even Rakesh Jhunjhunwala cannot be 100% sure of his estimated intrinsic value. Even he has acknowledged his mistake. So he will always discount his intrinsic value number. By what factor? It depends. This is what we will discuss in this article (How you can do it?)

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He will wait for the stock price to fall further down below the current level of Rs.110. Let’s say, he decided to keep a margin of safety of 10%. Hence he will wait for the stock price to fall to Rs.103 before making the purchase.

For some stocks, Rakesh Jhunjhunwala will accept a margin of safety of 10%, but for others, a 35% margin might look appropriate.

For investors, the margin of safety works as their safety net. In case the intrinsic value estimation is wrong, the margin of safety will help in minimizing or even eliminating the potential loss.

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