Stop! He who dares trade in the market of death must answer me these questions three. The the good return ye shall see!
Go ahead, tradekeeper, ask your questions.
WHAT is margin of safety as it applies to net present value?
If you’re using intrinsic value to make an investment decision, only buy if the security is trading at at least 50% below what you think it’s really worth. Everybody knows this.
WHAT is margin of safety as it applies to internal rate of return?
If you’re using expected return to make an investment decision, make sure the return you think you’ll make is above your hurdle rate and includes a factor for probability that something goes wrong times impact if it does.
If you’re taking this angle you’re probably evaluating a franchise and worried about the durability of its competitive advantage. If the company has an earnings power value of $2B but an asset reproduction value of $1B, your fear is that the moat gets breached and EPV collapses to ARV. If you think there’s a 10% chance of that happening, the factor would be ($1B/$2B – 1) x 10% = -5%, which you’d add to your expected return equation.
WHAT is margin of safety as it applies to buying individual securities?
Since buying an individual security is presumably riskier than buying the whole market via an index fund, you should only do so if the expected return is considerably higher than the market’s expected return.
Estimate the market’s return a couple of different ways in order to triangulate. Right now…
#1: S&P 500 P/E = 18.7 and long-term inflation is probably 1.5%.
Expected Return = 1 / 18.7 + 1.5% = 6.8%
#2: S&P 500 dividend yield is 2% and long-term GDP growth is hopefully 4%.
Expected Return = 2.0% + 4.0% = 6.0%
Conclusion: buying the market right now might give us 6-7%, so we’d really want to see an expected return of at least 11-12% for an individual company to find it interesting.