The Business of Value Investing.pdf

Effective Business Valuation 93

term in The Intelligent Investor , where he devoted an entire chapter

to expanding on its importance as the central concept in any invest-

ment operation. The concept of a margin of safety is the supreme

foundation of any business valuation. The margin of safety eliminates

catastrophic investment risks. When many investors are fi rst think-

ing about what gains an investment offers, the investor focused on

a margin of safety fi rst thinks about the likelihood of permanent

loss an investment offers.

The idea of a margin of safety stems from the reality that no

investor, not even Buffett, can determine the exact intrinsic value of

any business. Because a company ’ s intrinsic value is derived from ani-

nvestor ’ s calculated set of assumptions, intrinsic value is merely an

approximation. Sure, an investor as skilled as Buffett probably would

have a better approximation of intrinsic value than most, but then

again he ’ s been investing a lot longer than most of us. Nonetheless,

his assessment of intrinsic value is still an approximation. When you

invest with a margin of safety, you ’ re investing in such a way that

your success is not dependent on exact accuracy future forecasts.

This is why the margin - of - safety concept is of paramount impor-

tance to the valuation process. It gives the investor a degree of pro-

tection from the market ’ s uncertainties. There is no formula that

determines how wide a margin of safety you need. Obviously the

wider the better, and many value investors like a 50 percent mar-

gin of safety to feel really comfortable with making an investment.

And anything less than 25 percent is not signifi cant. Remember,

the point of a margin of safety is to account for the fact that you

are making estimates about the future results of the business and

any temporary uncertainties in the marketplace. Ultimately, the

business will dictate the degree of a margin of safety. A 30 percent

margin of safety in Wal - Mart is likely better than a 50 percent mar-

gin of safety in the Cheesecake Factory because you can estimate

with a higher degree of certainty the future cash fl ows of a large,

stable business that dominates its industry like Wal - Mart versus a

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