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Finding the Margin of Safety of a Stock

Successful long term investors look for stocks that are likely to provide strong cash flow, return on investment, and a degree of security over the years. The security in owning a good stock comes from its margin of safety. The official definition of margin of safety is that it is the difference between the market price of a stock and its intrinsic value. However, there
is more to the intrinsic value of a stock than a quick look at expected financial over the years. Finding the margin of safety of a stock may be easy and finding the margin of safety of a stock may take a little research and thought. Our premise is that finding the margin of safety of a stock through sound fundamental analysis is essential to profitable long term buy and hold investing.

Finding Value and What Counts for a Margin of Safety

Back to an accounting definition what is called break even analysis says that the margin of safety of a stock is the degree to which sales can fall before the company simply works to break even. This is a cash flow definition as opposed to a stock price definition and both can be quickly arrived at by looking at financials and calculating. The problem with both of these means of finding the margin of safety of a stock is that they are too easy to do and too prone to overlooking valuable assets the can eventually add value to a company and its stock. Learning how to invest for the long term includes learning to think outside the box, look past financials, and find assets that seem to be hidden to other investors and analysts. But just what are we looking for that might be hidden? Examples include the following:

  • Ignored stocks that are just starting to get going
  • Mismanaged companies with patents which they are not monetizing
  • Faltering old line companies with lots of unused or poorly used real estate

The point of finding the margin of safety of a stock is to buy it when its likely long term value is more than the current market price. The price may be down due to current economic conditions, poor current sales, or for number of reasons. However, if the stock’s margin of safety based on sound research is high it will be a good purchase for the long term buy and hold investor. What is a good investment? What are safe investments? Think of stocks with a strong long term cash flow. Think of stocks that will likely grow into the indefinite future. Think of stocks that are cheap when one considers their intrinsic stock value and margin of safety. Finding the margin of safety of a stock may take work but insight in this task improves with use. One does not need to invest all of his portfolio in one promising stock. If an investor thinks he has found a stock with a strong margin of safety and the stock never rises in value he can sell and move on. And keep in mind that some companies are so well entrenched in their markets that they make money year after year. These companies may well have overlooked assets as mentioned above but because the bulk of their shares are owned by those who don’t want change the margin of safety may remain as a safety net but never be realized in an increase in stock price. In this case sell and move on.

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