Margin of Safety
In previous chapters, you calculated the intrinsic value of businesses. When calculating the intrinsic value, you are using past owner earnings to try to project future owner earnings for the company for many years into the future. Future numbers are not going to be the same as those in the past. There may be multiple challenges in the future: The economy may slow down or go into a recession, a particular industry may fall into a temporary slump, or the company itself may develop problems and start to generate less revenue and earnings. You need to prepare for those kinds of variations; even if they happen, you should not lose money. This is where the margin of safety comes into play. You need to buy the stock at a discount to the calculated intrinsic value of the company.
For example, if you calculate the company’s intrinsic value to be $30 per share and you buy the shares at $20 per share, that is a 33 percent discount to intrinsic value. If you buy shares at a 50 percent discount to the intrinsic value of the company, that is excellent. Your investment return will likely be higher when your discount to intrinsic value is higher.
Suppose you are buying the stock at a 50 percent discount to intrinsic value and you keep the stock until it reaches its intrinsic value; here is the return calculation:
Scenario 1: Buying at a 50 percent discount to intrinsic value.
Company X intrinsic value: $25 per share
Average buy price: $12.50 per share
Duration: 2 years ...