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Margin of Safety
The single most important concept in value investment is the margin of safety, which is the difference between the market value of a company and its intrinsic value.
It is generally accepted that the pursuit of greater returns requires increased exposure to risk. However, by investing in companies with the greatest margins of safety, the value investor can both reduce risk and create a scenario where enhanced returns are most likely.
To illustrate the concept:
| Company | Intrinsic Value* | Market Capitalization | Margin of safety |
Anticipated Price Rise* |
| ABC | $10 billion | $9.5 billion | Nominal | 5.3% |
| XYZ | $10 billion | $6 billion | Substantial | 66.7% |
In this example, company ABC has a nominal margin of safety whereas company XYZ, being substantially under valued, offers a very high margin of safety.
XYZ is Likely to Produce Higher Returns
The underlying qualities (intrinsic value) of company ABC are reflected quite accurately in its current share price. Therefore, there is little rational basis to expect substantial change.
But the share price for company XYZ vastly underestimates the strengths of the company. The value investor would expect to see a gain of around 67% before the intrinsic value was fully reflected in the share price.
An investment into company XYZ is therefore likely to produce much higher returns.
XYZ is the Lower Risk Investment
Company XYZ is already trading at a substantial discount to its intrinsic value and any further fall in price is likely to be limited. The more undervalued a company becomes, the more likely it is that it will attract attention as a takeover target, attract the attentions of “bottom fishing” investors, or simply produce results that positively surprise the market and force investors to reassess the company’s value.
For company ABC, the share price might have to fall considerably before any of these supporting factors came into effect.
As a result, company XYZ is a considerably lower risk investment than Company ABC.
*The precise figures for intrinsic value (and the anticipated rise in share prices that result) is provided as an example to better illustrate the concept. In practice, we would never express intrinsic value as a definite figure given the subjective factors involved. We would instead discuss the margins of safety on offer in terms such as “nominal” or “substantial”, which still facilitates comparison for the purpose of ranking possible investment picks.