14 THE WARREN BUFFETT WAY
the company’s future income, but only to note the difference between
earnings and f ixed charges. If that margin was large enough, the investor
would be protected from an unexpected decline in the company’s in-
come. If, for example, an analyst reviewed the operating history of a
company and discovered that, on average, for the past f ive years the com-
pany was able to earn annually f ive times its f ixed charges, then that
company’s bonds possessed a margin of safety.
The real test was Graham’s ability to adapt the concept for common
stocks. He reasoned that if the spread between the price of a stock and
the intrinsic value of a company was large enough, the margin-of-safety
concept could be used to select stocks.
For this strategy to work systematically, Graham admitted, investors
needed a way to identify undervalued stocks. And that meant they
needed a technique for determining a company’s intrinsic value. Gra-
ham’s def inition of intrinsic value, as it appeared in Security Analysis,
was “that value which is determined by the facts.” These facts included
a company’s assets, its earnings and dividends, and any future def inite
prospects.
Graham acknowledged that the single most important factor in de-
termining a company’s value was its future earnings power, a calculation
that is bound to be imprecise. Simply stated, a company’s intrinsic value
could be found by estimating the earnings of the company and multiply-
ing the earnings by an appropriate capitalization factor. The company’s
stability of earnings, assets, dividend policy, and f inancial health inf lu-
enced this capitalization factor, or multiplier.
Graham asked us to accept that intrinsic value is an elusive concept.
It is distinct from the market’s quotation price. Originally, intrinsic
value was thought to be the same as a company’s book value, or the sum
of its real assets minus obligations. This notion led to the early belief that
intrinsic value was def inite. However, analysts came to know that the
value of a company was not only its net real assets but also the value of
the earnings that these assets produced. Graham proposed that it was not
essential to determine a company’s exact intrinsic value; instead, in-
vestors should accept an approximate measure or range of value. Even an
approximate value, compared against the selling price, would be suff i-
cient to gauge margin of safety.
There are two rules of investing, said Graham. The f irst rule is don’t
lose.The second rule is don’t forget rule number one.This “don’t lose”