There’s more to investing than just finding great stocks. There’s an actual strategy for determining if a stock is inexpensive, too expensive or priced just right. The price you pay for a stock has a major effect on how well you will do from both a risk and return perspective.
And thanks to Benjamin Graham, the father of Value Investing, now anyone can understand how to implement a solid valuation strategy for buying stocks.
Graham described his strategy in his classic book, The Intelligent Investor, and he specifically writes about an idea he calls the, Margin of Safety, in Chapter 20.
In fact, if you can only read two chapters in the book, Chapter 8 and Chapter 20 are the ones to read.
The idea behind the Margin of Safety is to purchase shares below their intrinsic value. The lower the price relative to the intrinsic value, the greater the Margin of Safety and the better insulated you are from uncertainty and errors in valuation.
The simple fact is, even great stocks can fall in value over the short term and excellent stocks can become significantly overpriced. If you don’t know how much a stock is worth based on its underlying company, you won’t know whether you’re buying at a good price or a bad one.
Let’s Look at an Example
For example, if you’ve calculated Apple’s (AAPL) intrinsic value to be $300, you might want to build in a 30% Margin of Safety just in case your calculation is wrong or some unexpected news causes Apple’s price to decline. So you might decide you will only purchase Apple’s shares at $210 or less (that is, 30% less than its intrinsic value).
If Apple is currently trading at $285, you would pass regardless of the fact the $285 price point is well below Apple’s intrinsic value of $300 (because at the current price there isn’t a sufficient built-in Margin of Safety).
Of course you can always monitor Apple until either the price drops to $210 or the intrinsic value increases sufficiently to justify a higher purchase price.
But how do you determine intrinsic value?
There are a number of methods, you can search for them on the Web, but regardless of the actual method used, it’s important to always try buying at a significant discount to the underlying company’s value (although you might have to wait for these discounts to materialize).
You should also be actively monitoring your current holdings and upgrading as better opportunities present themselves, or selling when your stocks become fully valued or their fundamentals change for the worse.
Patience is the key.
Sometimes you may be holding cash when overheated markets raise prices too high. Warren Buffett sat on the sidelines during the entire dot com bubble. But when prices came crashing down, he jumped in and bought like crazy. The reason he was able to do this is because he kept his cash available while scanning the markets for bargains, even while just about everyone else had their cash tied up in overpriced stocks.
It’s always preferable to err on the side of caution, use conservative valuation methods and consider worst case scenarios. Sometimes that will go against your nature of wanting to do something, especially when everyone else is buying into an overpriced market, but it’s important to ignore these urges and only act when the numbers tell you to act.
That way you can be sure your purchases will be made based on logic and you’ll pick up great stocks selling at bargain prices. And that’s how you ensure your portfolio has a significant Margin of Safety built in from the start.