Company valuation using the discounted cash flow method or other methods is not an exact science, but only an assessment for the rational price that the stock should be traded at. The real value depends on many factors, such as the growth rate of the company, its ability to maintain a certain level of profitability, the rate of capital investments and more, parameters that cannot be predicted accurately.
For example, we estimated a certain growth rate for the company, but a few months later, one of its competitors began to produce a similar product, leading to lower prices and lower growth. It is also possible that the company failed to develop one of its future products and needed to invest more money for further development. In all these cases, the fair price of the stock should be lower than what we predicted before.
To compensate for the uncertainties in our prediction of the company’s future results, we need to buy the stock well below the fair price we estimate. Applying this Margin of Safety when buying a share will significantly reduce the risk of losing money from our investment.
What level of margin of safety is required?
Clearly, buying a stock with a very high margin of safety can reduce the risk of a significant loss. However, the stock market is efficient most of the time, so buying shares only with a very large margin of safety will dramatically reduce the number of investment opportunities. Therefore, we must adjust the margin of safety to a reasonable level.
The greater the uncertainty regarding the future results of the company, the greater the margin of safety should be. For example, small or young companies are obviously less predictable than larger-leading companies, thus required a larger margin of safety. In addition, technological companies are less predictable compared to industrial companies, therefore required a higher margin of safety.
I usually prefer to by $1 in 50 cents, meaning a 50% margin of safety, but this is not always possible. As a rule of thumb, try to buy only shares that are traded at least 15-20% below their fair value. This will compensate for the uncertainties in the valuation process and on the long-term increase your chances of gaining returns larger than the indices. In case of smaller companies or ones that are related to more volatile industries (such as technology or bio-medical) use a higher margin of safety of at least 25%-30%. Buying at this level of margin of safety will dramatically reduce your risk of losing money.
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