books about online stock trading, forex, futures, stock investing, market, trading systems
Have a Margin of Safety
Back to contents page

Finding great companies is only half of the investment process—the other half is assessing what the company is worth. You can't just go out and pay whatever the market is asking for the stock because the market might be demanding too high a price. And if the price you pay is too high, your investment returns will likely be disappointing.

The goal of any investor should be to buy stocks for less than they're really worth. Unfortunately, it's easy for estimates of a stock's value to be too optimistic—the future has a nasty way of turning out worse than expected. We can compensate for this all-too-human tendency by buying stocks only when they're trading for substantially less than our estimate of what they're worth. This difference between the market's price and our estimate of value is the margin of safety.

Take Coke, for example. There's no question that Coke had a solid competitive position in the late 1990s, and you can make a strong argument that it still does. But folks who paid JO times earnings for Coke's shares have had a tough time seeing a decent return on their investment because they ignored a critical part of the stock-picking process: having a margin of safety. Not only was Coke's stock expensive, but even if you thought Coke was worth JO times earnings, it didn't make sense to pay full price—after all, the assumptions that led you to think Coke was worth such a high price might have been too optimistic. Better to have incorporated a margin of safety by paying, for example, only 40 times earnings in case things went awry.

Always include a margin of safety into the price you're willing to pay for a stock. If you later realize you overestimated the company's prospects, you'll have a built-in cushion that will mitigate your investment losses. The size of your margin of safety should be larger for shakier firms with uncertain futures and smaller for solid firms with reasonably predictable earnings. For example, a 20 percent margin of safety would be appropriate for a stable firm such as Wal-Mart, but you'd want a substantially larger one for a firm such as Abercrombie & Fitch, which is driven by the whims of teen fashion.

Sticking to a valuation discipline is tough for many people because they're worried that if they don't buy today, they might miss the boat forever on the stock. That's certainly a possibility—but it's also a possibility that the company will hit a financial speed bump and send the shares tumbling. The future is an uncertain place, after all, and if you wait long enough, most stocks will sell at a decent discount to their fair value at one time or another. As for the few that j ust keep going straight up year after year—well, let's j ust say that not making money is a lot less painful than losing money you already have. For every Wal-Mart, there's a Woolworth's.

One simple way to get a feel for a stock's valuation is to look at its historical price/earnings ratio—a measure of how much you're paying for every dollar of the firm's earnings—over the past 10 years or more. (We have 10 years' worth of valuation data available free on Morningstar.com, and other research services have this information as well.) If a stock is currently selling at a price/earnings ratio of 30 and its range over the past 10 years has been between 15 and 33, you're obviously buying in at the high end of historical norms.

To justify paying today's price, you have to be plenty confident that the company's outlook is better today than it "was over the past 10 years. Occasionally, this is the case, but most of the time when a company's valuation is significantly higher now than in the past, watch out. The market is probably overestimating growth prospects, and you'll likely be left "with a stock that underperforms the market over the coming years.

We'll talk more about valuation in Chapters 9 and 10, so don't "worry if you're still wondering how to value a stock. The key thing to remember for now is simply that if you don't use discipline and conservatism in figuring out the prices you're "willing to pay for stocks, you'll regret it eventually. Valuation is a crucial part of the investment process.

Smarter trading The art of day trading Trading Chaos Sane Investing In An Insane World
Beat The Odds In Forex Trading