Even if the company is consistent and you have done a good valuation of the company, share price may fall and company performance may get affected by short term incidents or a bear market.
If the investing price of the share of a company is very close to its expected valuation, it may still be risky to invest, as some unforeseen events, like corona, may effect companies estimated revenues.
So you want to buy the company much under value to your valuation price.
A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.Mr Seth Klarman
Margin of Safety : This is the difference of actual undervalued buying price and estimated intrinsic value of stock .
While Mr Ben Graham recommended to buy shares at 1/4th or 25% of its estimated intrinsic value, you will rarely get such prices these days. This does not mean that you will NOT get it, it just means you have to be patient and wait for low PE Ratio stocks.
If you buy stock with a sufficient margin of safety, the probability is with you.Li Lu
The other way to look at Margin of Safety is that it corrects for your Margin of error in estimating its valuation !
There are many who believe in the Efficient Market hypothesis which in simple terms means that share price will reflect and get corrected to the information available to all and thus it is very difficult to "BEAT THE MARKET", however value investors have proved them wrong many times.
With this new learning, let us modify our
Thumb Rules for Stock Investment
- Default mode is DO NOT INVEST
- Verify Financial statement source of Information. Best is to do financial statement analysis personally.
- If you do not understand the financial statement, safely switch to default mode, DO NOT INVEST. Period !
- Check Financial ratios for fundamental analysis, if not sure, switch to default mode, DO NOT INVEST.
- Cannot value a stock, switch to default mode, DO NOT INVEST.
- Cannot determine probability of earning, NO Margin of Safety, outside your Circle of competency, DO NOT INVEST.
Margin of safety is just 1 factor of many factors which can improve your Stock market probability of earning, in coming chapters of Share market course tutorial , we will detail some more. For now let us see how to find undervalued stocks.
VALUE INVESTING STOCK INVESTMENT FINANCIAL PLANNING FINANCIAL RATIOS VALUING STOCKS