February 7, 2016

3 Simple Ways to Assess "Margin of Safety": The Cornerstone of Stock Investing

We all have faced situations in life where our decisions have gone wrong. Be it personal or professional life, our assumption are proven erroneous and the outcome is different from what we had anticipated. Stock investing is no different!

We can never be certain that the stock, which we have selected with significant hard work, would always go up in price. No one can assure us that the company, which the stock represents, would keep on growing the way it did in the past. All these elements bring an aspect of risk in investing. 

The risk is that the company or the market will prove an investor’s analysis wrong and instead of generating wealth from the markets, she would end up losing her hard earned money. And if not handled diligently, these errors might put her financial freedom at stake.

One of the all-time best investors, Benjamin Graham, dealt with this situation lucidly in his book “The Intelligent Investor”. Graham highlighted that no matter how careful an investor is, she can never eliminate the risk of being wrong. To tackle this situation Graham introduced the concept of “Margin of Safety” in investing.

Methods to measure margin of safety in a stock investment: Earnings Yield, Self Sustainable Growth Rate and Free Cash Flow



Graham presented Margin of Safety as a tool of minimizing the odds of error in an investor’s favour. He stressed that Margin of Safety meant never overpaying for a stock, however attractive the investment opportunity may seem. The Margin of safety would provide a cushion for unforeseen adverse developments affecting the investment decision.

Graham in his book “The Intelligent Investor”, first published in 1949, provided a simple tool for investors to measure the margin of safety in a stock investment. He advised investors to compare earnings yield of a stock to the yield on the bonds (Government Securities in India) to arrive at the margin of safety.

Since the days of Graham, the concept of Margin of Safety has been interpreted differently by different investors and many of them have come up with their own parameters for determining the Margin of Safety in an investment. Be it Warren Buffett, Peter Lynch or any other investor, everyone follows certain guidelines to assess, what qualities would protect their investment in case things do not turnout the way they have anticipated.

Over last 10 years of investing in equity markets and after analysing hundreds of companies & stocks, I find that there are three different parameters, which provide an objectively measurable assessment of margin of safety. These parameters identify the margin of safety built in the purchase price as well as in the business model of any company and have served me well.

In the current article, I would detail these parameters of assessing Margin of Safety in any stock investment along with the tools to measure it.

A) Margin of Safety in the purchase price:

  • Earnings Yield being higher than 10 years bond (Government Securities) yield

B) Margin of Safety in the business of the company:

  • Self Sustainable Growth Rate (SSGR) being higher that current sales growth
  • Positive Free Cash Flow (FCF) post meeting entire capex


Let’s now deal with each of these three parameters of Margin of Safety one by one.


Earnings Yield

Earnings Yield (EY) as a measure of Margin of Safety, was proposed by Benjamin Graham in his book “The Intelligent Investor”. Earnings Yield is calculated as inverse of Price to Earnings (P/E) ratio i.e. E/P ratio. It is calculated by dividing the earnings per share (EPS) with the current market price (CMP). 

EY provides an idea about the earning/returns that a stock would produce for every INR invested by the buyer in it.


Benjamin Graham advised comparing the EY with Treasury Yield (USA). Similar yield to compare in India is the ongoing yield on Government Securities (G-Sec). The higher the difference between EY and G-Sec/Treasury Yield, the safer is the stock investment.

To illustrate, suppose an investor buys a stock of company ABC Ltd at ₹100. If EPS of ABC Ltd is ₹10 then its P/E ratio would be 10 (100/10) and its EY would be 1/10 or 10%. As current G-Sec yield is about 7.50-8.00%, ABC Ltd is a good investment as per Graham’s criteria.

Suppose, after the investor buys the stock of ABC Ltd., its price falls to ₹50, then the P/E ratio would become 5 and the EY would become 1/5 i.e. 20%. EY of 20% would attract more and more investors to shift money from bonds markets and use it to buy stocks of ABC Ltd. as it provides an opportunity to invest money at a yield of 20% against G-Sec yield of 8%. This new demand for stocks of ABC Ltd. would increase its stock price and limit the downfall.

The higher the difference between EY and G-Sec/Treasury yield at the time of purchase of the stock, the higher is the cushion in times of adversity i.e. higher Margin of Safety. Therefore, the stocks with higher earnings yield (EY) i.e. the ones with low P/E ratio, would provide a higher cushion to the investor during tough times.

The above argument makes me choose my stock in the segment of P/E ratio of 10 or less as these stocks provide a margin of safety. However, it remains critical to differentiate fundamentally sound companies available at low P/E ratio from the troubled companies, which form the junkyard of stock markets.

You may read more about it in the following article:


Self-Sustainable Growth Rate

Self-Sustainable Growth Rate (SSGR) is a measure of the growth potential inherent in the business model of a company, which it can achieve using resources generated through its current profits without relying on external sources of funds like debt or equity dilution.

Self-Sustainable Growth Rate (SSGR) utilizes the features of a company’s business model like: net profit margin (NPM), dividend payout ratio (DPR), depreciation (Dep) and net fixed asset turnover (NFAT) to arrive at the sales growth rate that the company can achieve without leveraging itself.

The formula for calculating SSGR is:

SSGR = [(1-Dep) + NFAT*NPM*(1-DPR)] – 1

(I advise that the readers should read the following article dedicated to SSGR, in case they have not read it already, before proceeding further in order to fully understand the concept and implications of SSGR:

It can be inferred from the above formula, the companies with higher profitability (NPM), operating efficiency (high NFAT) and lower dividend payouts (DPR) would have higher self-sustainable growth rate (SSGR).

An investor should compare the SSGR of the company with its current sales growth to see if there is any margin of safety in the business of model of the company:

1) If the SSGR is higher than current sales growth rate: 

It means that the company’s business features (NPM, NFAT & DPR) allow it to grow its sales at a higher rate than the current growth rate. In case of economic downturn, the company can safely:
  • reduce its profitability to generate higher demand
  • reduce dividends to conserve funds to make additional investments and
  • invest in fixed assets to improve its plant & machinery/technology (leading to lower NFAT)

in an attempt to maintain its current sales growth rate. 

All the above steps would provide funds from business activities and the company would not have to rely on external sources like debt or equity dilution to get funds to maintain its current growth rate.

Therefore, the company with higher SSGR can increase their sales growth rate in normal times and maintain current sales growth rate during tough times without leveraging their balance sheet by taking on debt.

The examples of FDC Limited, Container Corporation Limited and Hindustan Unilever Limited have been discussed in the article on SSGR. These companies have SSGR higher than their current sales growth and therefore are able to stay debt free while maintain their growth.

Additionally, we may see the performance of another company: VST Tillers Tractors Limited:

Methods to measure margin of safety in a stock investment: Earnings Yield, Self Sustainable Growth Rate and Free Cash Flow


Business model of VST Tillers Tractors Limited, provides it the ability to grow at a much higher growth rate (SSGR=55-65%) than its achieved sales growth rate of 17% over past 10 years. VST Tillers Tractors Limited has significant cushion to reduce its profitability, dividend payout ratio and fixed asset turnover during tough times and still not fall into debt trap, thereby providing a resilient business model and a high margin of safety to the investor.

2) If the SSGR less than current sales growth rate:

The investor would notice that such companies are already growing more than their business potential. Such companies usually rely on raising debt or diluting their equity to generate funds needed for investments to generate the sales growth.

In the article on SSGR, we have seen examples of Castex Technologies Limited (erstwhile Amtek India Limited), Metalyst Forgings Limited (erstwhile Ahmednagar Forgings Limited) and Glenmark Pharmaceuticals Limited and Polyplex Corporation Limited. 

These companies are growing at a sales growth rate which is much higher than their business potential (SSGR). The result was that these companies had to consistently raise debt/dilute equity to raise funds for investments to generate the growth, as their operational business was not able to generate required amount of funds.

Let us see an additional example of LT Foods Limited, manufacturer of popular branded rice “Daawat”:

Methods to measure margin of safety in a stock investment: Earnings Yield, Self Sustainable Growth Rate and Free Cash Flow


LT Foods Limited has been growing its sales at a growth rate of about 22-23% over last 10 years, however, its business model indicates that in the current situation it is not able to sustain any growth beyond 7% in the business as its SSGR is almost 0-7%. LT Foods Limited has to raise almost entire amount of funds to support its growth from additional sources like debt.

It is not surprising that LT Foods Limited has witnessed its debt increase from ₹224 cr. in FY2006 to ₹1,692 cr. in FY2015.

Rising debt levels increase the bankruptcy risk of the business during tough times as we have seen recently in case of Electrosteel Steels Limited, which has been taken over by its lenders.

3) If the SSGR is equal to current sales growth rate:


It means that company is already using its business potential to the maximum and the company would find it hard to maintain its current growth rate in tough business scenarios characterized by industry-wide declining profitability. Similarly, the company would have to raise additional funds by way of debt or equity for funding, in case the company decides to increase its growth further.


Therefore, I find that the business model of the companies with SSGR higher than current growth rate, is more resilient and sustainable during downturns. Thus SSGR forms key parameter to assess the margin of safety in the business model of a company in my stock analysis.

I advise investors to prefer companies that have self-sustainable growth rate (SSGR) higher than their achieved sales growth rate over those companies that have SSGR less than their sales growth rate. The higher the SSGR, the better. High SSGR increases the margin of safety in the business and the capacity to bleed in times of stress without putting the entire business and its shareholders at risk.



Free Cash Flow

I believe that free cash flow (FCF) is the ultimate measure of investibility of any company. It is calculated as the surplus cash with the company after meeting its capital expenditure requirements.

FCF = CFO – Capex
Where,
  • CFO = cash flow from operations
  • Capex = capital expenditure including maintenance capex and capital work in progress (CWIP)

Capex for any year can be calculated as the difference between gross fixed assets (GFA) & CWIP at start of the year and end of the year. It can also be calculated by deducting net fixed assets & CWIP at start of the year from the net fixed assets & CWIP at end of the year and adding back the depreciation for the year. 

Capex:
(GFA + CWIP) at the end of the year – (GFA + CWIP) at the start of the year

OR

(NFA + CWIP) at the end of the year – (NFA + CWIP) at the start of the year + Depreciation for the year


Free cash flow (FCF) is the most essential feature of any business as it amounts to the surplus/discretionary cash that the business/company is able to generate for its shareholders. FCF is the equivalent of savings for a household

If we as households are not able to manage our expenses within our means of income, i.e. are not able to save anything, then our financial health is going to suffer a lot in future. We would have to borrow from relative/banks etc. to meet our requirements. The debt, which we raise to fund our expenses, needs to be paid at predefined intervals irrespective of the fact whether we are able to save in future/have our job intact or not. The debt pressure increases the bankruptcy risk and leads to stress in our lives. 

The scenario is exactly the same for companies as well. 

If a company does not have positive free cash flow, it means that it is spending beyond its means. Such a company would have to raise funds from additional sources like debt or equity dilution to meet its requirements. These funds, if raised from debt, would decrease profitability by interest expense and increase bankruptcy risk and if raised from equity, would lead to dilution of stake of existing shareholders. 

In both the cases the situation of companies continuously raising debt/equity to meet their cash flow requirements, becomes less attractive for investors as compared to the companies that are able to meet their funds requirements from their cash flow from operations.

It might be argued that the investments done today by the company would lead to revenue & profits in the future and would generate wealth for the shareholders. 

This argument is a valid argument just like an educational loan for an individual. An education funded by loan is an investment, which has the potential of increasing the skills set, earnings ability and future wealth of a person and therefore is considered a good investment.

Similarly, for companies the investments in plants & machinery and technology is like educational loan, which increases future earnings potential. Therefore, we should not worry about the situation where a company is not able to generate positive FCF for a few year. Such companies might be taking education loans to generate future wealth. However, if a company is not able to generate positive FCF over long periods of time (I assess them over last 10 years), then the company resembles a continuous cash guzzling machine

It resembles an individual who is continuously garnering degrees after degrees costing millions of rupees/dollar, without ever putting those skills to commercial use. Or those degrees might be fake and cash has already gone down the drain! In both the cases, the investment done is not of much use.

I, as a shareholder, expect the companies I own, to be cash generating machines. Their business should be source of cash for me and not the other way round. Therefore, positive free cash flow generation by a company over last 10 years, is one of the key criteria for stock selection for me.

Once an investor has identified a company with positive cash flow, then she should further analyse what proportion of cash flow from operations (CFO) over last 10 years, it has used in capital expenditure (capex) and what proportion is available as free cash flow (FCF).

Free Cash Flow and Margin of Safety:


I find that the companies, which have achieved their sales growth in the past by using minimum amount of CFO as capex have significantly higher margin of safety over the companies which have used almost all CFO. Needless to say the companies, which have their capex much higher than their entire CFO over last 10 years (i.e. negative FCF), have very low/negative margin of safety.

An illustration:

Let’s take an example of two similar sized companies (A & B) growing their sales at a similar rate (say 15%) in the past. Let’s assume that both the companies A & B, generated same amount of CFO over last 10 years (say ₹100 cr).

Let’s assume that on analysing the capex done by these companies in last 10 years, we find company A has achieved the sales growth (15%) by doing a capex of ₹50 cr (50% of CFO), thereby, generating a FCF of ₹50 cr. On the contrary, we find that the company B has achieved the same sales growth (15%) by doing a capex of ₹100 cr (100% of CFO), thereby, generating NIL FCF.

When the tough times strike the economy in future, the profitability of companies would decline, customers would delay the payment of cash, suppliers would ask for immediate cash and the credit from all sources would become costly. 

In such a situation, company A, whose business model permitted it to achieve the sales growth by using only 50% of CFO in the past, would be able to bear the impact of reducing cash inflows as customers cancel their orders, squeeze profit margins and delay the payments. Theoretically, company A can tolerate its profitability and cash collections (CFO) declining by 50%, before signs of stress start becoming visible on its business operations & planned investments.

On the other hand, company B, which was already investing 100% of its CFO to generate its sales, would find even the slightest decline in its cash flow (CFO), impacting its operations. Declining orders, reduced profitability and delayed payments from customers would make it difficult for company B to make payments to its suppliers and do planned investments. Company B would have to rely on additional debt/equity raising to fund its cash requirements.

If there is another company C, which was already using more than 100% of its CFO in capex, thereby having negative free cash flow (FCF). Such a company would already be sagging down under lot of debt burden. In tough economic situation described above, company C would find difficult to continue its business operations as usual as sources of cash dry up. The additional debt, which was essential to sustain its business model, would become further costly.

Companies like C are prime candidates for bankruptcy in tough times as they find it difficult to service exiting debt, make payments to suppliers. Such companies, usually being capex heavy and operating at low profit margins, find it difficult to garner additional business by reducing their profitability as it would push them into losses. Such companies rarely have any margin of safety built in their business model.

Let us see the real life examples of companies with different levels of free cash flow (FCF) generation:

Hindustan Unilever Limited (HUL) is a prime example of a company, which has been able to generate a lot of free cash flow from its operations over the years.

Methods to measure margin of safety in a stock investment: Earnings Yield, Self Sustainable Growth Rate and Free Cash Flow


Over last 10 years (FY2006-15), HUL has generated cash flow from operations (CFO) of ₹26,298 cr. whereas it needed to invest only ₹3,718 cr. in its business and thereby leaving ₹22,579 cr. in hand of the company as discretionary cash to reward its shareholders. No wonder, the company could provide dividends to the tune of ₹20,543 cr. over last 10 years despite remaining virtually debt free.

HUL presents an example of a very attractive business, which offers 86% of the cash generated to its owners as free cash without compromising on its future growth. This represents a huge amount of margin of safety built into the business. 

During tough times, HUL can reduce prices of its products, offer higher credit period to its customers, pay suppliers promptly to attract and retain quality suppliers without impacting its balance sheet. It would not need to raise debt for such crisis strategies; only a slight reduction in the dividend payouts to the shareholders would provide enough of money to fund the emergency measures.

No wonder, the market loves it and its shares trade at P/E ratio of high 40s.

On the contrary, we can see the example of Tata Steel Limited, which has been acting as a cash guzzler for its shareholders:

Methods to measure margin of safety in a stock investment: Earnings Yield, Self Sustainable Growth Rate and Free Cash Flow


Over last 10 years (FY2006-15), Tata Steel Limited has generated cash flow from operations of ₹105,565 cr. However, its business required it to invest whopping ₹126,073 cr in the company, thereby eliminating any chance of free cash flow. The company, on the contrary, had to raise debt to fund its capital expenditure requirements. Total debt of the company increased from ₹3,377 cr. in FY2006 to ₹80,701 cr. in FY2015.

If an investor analyses deeply, then she would notice that the entire dividend of ₹9,547 cr., paid by the company over last 10 years has been funded by debt.

If the economic scenario deteriorates further, then the company would have to meet its cash requirements by raising further debt or equity. Incase its lenders or shareholders, do not provide this capital, then the company would face difficult time to tide over the crisis.

Looking at the above situation, it is clear that Tata Steel Limited does not have a significant margin of safety built into its business model and the market has realized it.

No wonder, the stock is available at a P/E ratio of low single digits.

Therefore, an investor can see that positive FCF is a necessity before considering any company for investment and the fact that higher the FCF as proportion of CFO, the higher the margin of safety.


After reading our entire discussion, an investor would realize that there are two major source of margin of safety in a stock investment, which can help an investment in the adverse scenarios in future:

A)  Margin of safety built in the purchase price of the investor:

  • Determined by the Earnings Yield of the stock. The higher the earnings yield than the ongoing treasury/G-Sec yield, the higher the margin of safety.

B) Margin of safety built in the business model of the company:

  • Self Sustainable Growth Rate (SSGR): Higher the SSGR than its achieved sales growth rate, higher the margin of safety
  • Free Cash Flow (FCF): Higher the proportion of cash flow from operations (CFO) available as free cash flow (FCF) post meeting all the capital expenditure requirements, higher is the margin of safety.

An investor should always look out for companies with high SSGR, FCF and available at good earnings yield.

The investor would notice that most of the well-known companies in the market, which have high margin of safety in their business, are already trading at high P/E multiples and therefore preclude any margin of safety in the purchase price. Similarly, among the well-known companies, most of the companies, which are available at low P/E ratio, thereby providing margin of safety in the purchase price, do not have high margin of safety in the business.

Therefore, it becomes critical for the investor to search for companies, which have high margin of safety in the business and at the same time, are available at low P/E ratios. If an investor is able to find such companies, then she can certainly generate significant amount of wealth through stock markets.

Such companies, which have a combination of high margin of safety in the business as well as high margin of safety in the purchase price, are prime candidates to turn out to be multibaggers in future.

It is to emphasize that an investor does not need to find hundreds of such companies. Only a few of them over her entire lifetime can do wonders to her wealth. Even the best investor of all times, Warren Buffett, acknowledges that most of his wealth has come from only a handful of stock picking decisions turning out to be right.

All the best for your investment journey!


I have shared the learning that I have had in my investing journey related to the margin of safety, which I believe that could be useful to other investors. It’s your turn now.

Share your experiences and let the other readers and the author know about the ways you assess the margin of safety while making an investing decision. It would be a pleasure to read your experience and investing strategy.

It would be great to have your feedback about the current article and the website.

P.S:



DISCLAIMER


The views and opinions expressed or implied herein are my own and do not reflect those of my employer, who shall not be liable for any action that may result as a consequence of my views and opinions.

Registration Status with SEBI:


I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013, since May 25, 2016.

Details of Financial Interest in the Subject Company:


Currently, I do not own stocks of any of the companies discussed above. I have disclosed stocks in my portfolio on a dedicated page (My Portfolio). I request you to see the list of stocks I own, because it is assumed that my views can be biased when I opine about any stock which I own and therefore, have a financial interest.