The Margin of Safety: How to Buy Stocks on Sale

Benjamin Graham observed that real key to successful investing is not just identifying high quality companies with good growth prospects. It is to buy such companies as cheaply as possible, leaving what he called a "margin of safety." The margin protects the investor against forecasting errors and the tyranny of "events."

Two approaches are presented here:

Growth model: This is the ratio of the PE ratio to the sum of dividend yield and estimated EPS growth rate. If it is less than one, then the stock is presumed to be selling at a discount to its growth prospects. It is a variant of the so-called PEG ratio.

Cash flow model: This approach compounds free cash flow plus common stock dividends forward for 10 years at the estimated EPS growth rate. It then capitalizes that cash flow in the 10th year at the modest rate of 10%. Lastly it discounts this stream of cash flows at the historical equity return of 9% (after inflation) and divides the result into Market cap minus cash on hand. If this ratio is less than one, then the stock is presumed to be selling at a discount to its enterprise value.

Investigate the margin of safety for your favorite stock by inputting the relevant variables into the interactive model below.

The personal information:
  • PE Ratio: Ratio of the current stock price to trailing 12 months earnings per share.
  • Dividend Yield: Indicated dividend divided by current stock price. (%)
  • Market cap: Current stock price times total shares outstanding. ($MM)
  • Cash on hand: Cash and cash equivalents as stated in the current asset section of the balance sheet. ($MM)
  • Free cash flow: From the statements of cash flows, the amount of cash from operations left over after paying capital expenditures and common stock dividends. This is amount of money management can use to good effect by reducing leverage, buying back stock or increasing dividends. Consider using a 2-3 year average to smooth out one-time effects.($MM)
  • Your personal estimate of future EPS growth rate: In italics because it is the 64 dollar question. It is your estimate of the growth potential of the company in this next 7-10 year phase. It is not the past growth rate , although this could have some bearing on the company's earning momentum. Companies who have been growing well and are now stalling out are "value traps." They look cheap but are actually expensive. Make your own estimates or rely on those of Wall Street securities analysts - or maybe a blend of the two. (%)

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