The process by which stock analysts and others who invest for a living determine what a stock is actually worth is called discounted cash flow analysis. This process is based on the premise that a company is only worth the sum of its earnings discounted back to some present value, where the discounting factor is the sum of the yield on U.S. treasury bonds plus some desired additional rate of return. For a visual lesson on how to perform a discounted cash flow analysis on your own, check out the video below.
After determining how much a company is worth using a discounted cash flow analysis, you should compare that value (make sure to divide the company value by the number of shares outstanding) to the actual stock value. For instance, if your DCF analysis tells you that a company is worth $34 a share, but it is trading at $22 a share on a stock exchange, then the stock is trading at a 36% discount (($34 - $22)/$34) to its intrinsic value. In other words, this stock has a 36% margin of safety. If on the other hand, your DCF stated that the stock was worth $15 and it was trading at $24, there would be no margin of safety. Benjamin Graham and Warren Buffett warn against buying stocks with no margin of safety or even small margins of safety since the margin of safety concept is intended to shield the investor from his own errors.
If you watched the video above, you saw that the stock analyst has to make lots of projections as to the growth rate of a company, potential tax rates, and the rates at which operating expenses will grow. And the more things one has to project, the easier it is to get things wrong. Fortunately, one doesn't have to use a DCF analysis in order to determine if a stock provides adequate margin of safety. She can just look at the metrics that I pointed to in the last post: P/E, P/BV, and P/FCF.
The faster that a company is growing, the higher that its P/E will usually be. As a general rule, the investor should look for companies that are growing fast, but have comparatively low P/Es (under 15x). A comparatively low P/E ratio, along with a growth rate that is equal to or higher than the nominal P/E (the actual number for the P/E), is indicative of a margin of safety.
Here's a quick example because I know that last sentence was a little confusing. Let's say you find a stock with a P/E ratio of 10. This is a great start, but if it the underlying company is growing at 5% a year, there might not be a margin of safety. Conversely, if a stock is trading at 10x earnings, but growing at 14% a year, this is certainly indicative of a margin of safety and it means the stock warrants further investigation!
Price to Book Value
As I mentioned last post, the book value of a company is the total amount of assets minus the total amount of liabilities. Essentially, it is the surplus, or what really makes a company valuable. When looking for margin of safety using this metric, just as when you are using the P/E, lower numbers are better. (Usually a multiple in between 2x and 4x is considered low.) When a company has a low price to book value, often times its assets - such as land that is being accounted for on the balance sheet at cost - are being woefully undervalued. The trick though, is to find companies with low P/BV and low, but steady growth and a dividend. The stock market treats steady growers very well, especially if they have a dividend. Low P/BV with a dividend usually means a margin of safety because even if you are wrong about the assets being undervalued, the dividend will provide downside cushion, AND, the market will probably not punish the stock for missing earnings estimates since its multiple is already so low.
In the next post, I will talk about the last major valuation metric, which is Price to Free Cash Flow. We'll get a little into the weeds, but it will be worth it.