Margin of Safety in Stock Investing: A Complete Guide

Modified: 08-Jun-21

The current article explains all the aspects of Margin of Safety in stock investing including its meaning, calculations and the tools to be used. The article also clarifies some of the common queries of investors related to the margin of safety.

We all have faced situations in life where our decisions have gone wrong. Be it personal or professional life, our assumptions 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.

Graham presented the Margin of Safety as a tool for 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 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 turn out the way they have anticipated.

Over the 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.

Simple Steps to assess Margin of Safety in a Stock

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 than current sales growth
  • Positive Free Cash Flow (FCF) after meeting entire capex

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

A) 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 the 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 the 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 at a low P/E ratio 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 articles:

B.i) 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 = NFAT*NPM*(1-DPR) – Dep

Where

  • SSGR = Self Sustainable Growth Rate in %
  • NFAT = Net fixed asset turnover (Sales/average net fixed assets over the year)
  • NPM = Net profit margin as % of sales
  • DPR = Dividend paid as % of net profit after tax
  • Dep = Depreciation rate as a % of net fixed assets

(For details of step by step algebraic calculation of SSGR formula: Click Here)

We have provided a sample mathematical manual calculation of SSGR for a sample case (FDC Ltd) in the SSGR article. You may refer to the SSGR article to understand more about how we calculate SSGR in our analysis.

(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: Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company)

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 the 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 the case of an 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.

Let us see the performance of a company: Paushak Ltd.

Paushak Ltd is India’s largest phosgene based speciality chemicals manufacturer. Paushak Ltd is a part of the Alembic Pharmaceuticals group.

While doing analysis of Paushak Ltd, an investor notices that the company has an SSGR in excess of 40-50% whereas its sales have grown at a rate of 15-20% year on year in the last 10 years.

Paushak Ltd Self Sustainable Growth Rate SSGR 1

The business model of Paushak Ltd provides it with the ability to grow at a much higher growth rate (SSGR=50-70%) than its achieved sales growth rate of 19% over the past 10 years. Paushak Ltd has significant cushion to reduce its profitability, dividend payout ratio and fixed asset turnover during tough times and still not fall into a debt trap, thereby providing a resilient business model and a high margin of safety to the investor.

An investor may read our detailed analysis of Paushak Ltd in the following article: Analysis: Paushak Ltd

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 sales growth.

In the article on SSGR, we have seen many examples of companies 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 growth, as their operational business was not able to generate the required amount of funds.

Let us see an example of Rain Industries Ltd.

Rain Industries Ltd is the world’s second-largest manufacturer of calcined pet coke (CPC) and coal tar pitch (CTP) used primarily in aluminium production.

While analysing Rain Industries Ltd, an investor notices that the company has an SSGR of zero or negative whereas it has grown its sales by about 13-14% year on year for the last 10 years.

Rain Industries Ltd Self Sustainable Growth Rate SSGR

Rain Industries Ltd has been growing its sales at a growth rate of about 15% over last 10 years; however, its business model indicates that in the current situation it is not able to sustain any growth in the business as its SSGR is almost 0%. Rain Industries Ltd has to raise almost the entire amount of funds to support its growth from additional sources like debt. As a result, the total debt of the company has increased from ₹3,178 cr in FY2010 to ₹7,845 cr in FY2019.

An investor may read our detailed analysis of Rain Industries Ltd in the following article: Analysis: Rain Industries Ltd

Rising debt levels increase the bankruptcy risk of the business during tough times as we have seen recently in multiple cases in the Indian corporate world like Essar Steel Ltd.  Many of these companies were sold by lenders to new promoters to recover their money.

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

It means that the 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 the current growth rate is more resilient and sustainable during downturns. Thus SSGR forms a 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 a 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.

Read: Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company

B.ii) Free Cash Flow

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

FCF = CFO – Capex

Where,

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

Read: Understanding the Annual Report of a Company

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. 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 the 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 the loan is an investment, which has the potential of increasing the skills set, earning ability and future wealth of a person and therefore is considered a good investment.

Similarly, for companies, the investment in plants & machinery and technology is like an 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 years. 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 the 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 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 a source of cash for me and not the other way round. Therefore, positive free cash flow generation by a company over the 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 the minimum amount of CFO as capex have a 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 the 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 the same amount of CFO over the 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 an 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 a lot of debt burden. In a tough economic situation described above, company C would find it 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 existing 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:

1) Positive Free Cash Flow:

Honeywell Automation India Ltd is a part of Honeywell group, USA, is its Indian subsidiary working in automation and control systems in industries, buildings, automobiles etc. It 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.

Honeywell Automation India Ltd Free Cash Flow

Over the last 10 years (FY2010-2020), Honeywell Automation India Ltd has generated cash flow from operations (CFO) of ₹1,501 cr. whereas it needed to invest only ₹294 cr. in its business and thereby leaving ₹1,207 cr. in the hand of the company as discretionary cash to reward its shareholders. No wonder that the company could provide dividends to the tune of ₹198 cr. over the last 10 years and still increase its cash & investments by more than ₹1,000 cr over the last 10 years. In addition, the company is virtually debt-free. The liability of ₹81 cr shown in FY2020 is due to changes in the accounting treatment of leased assets where now, the lease liabilities are shown as debt.

Honeywell Automation India Ltd presents an example of a very attractive business, which offers 80% 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, Honeywell Automation India Ltd can reduce prices of its services, offer higher credit period to its customers, pay its vendors 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 money to fund the emergency measures.

No wonder, the market loves it and its shares trade at P/E ratio in the 50s.

An investor may read our detailed analysis of Honeywell Automation India Ltd in the following article: Analysis: Honeywell Automation India Ltd

2) Negative Free Cash Flow:

On the contrary, we can see the example of Filatex India Ltd, an Indian manufacturer of polyester, nylon & polypropylene multifilament yarn, which has been acting as a cash guzzler for its shareholders.

Filatex India Ltd Free Cash Flow

Over the last 10 years (FY2011-20), Filatex India Ltd has generated cash flow from operations of ₹791 cr. However, its business required it to invest ₹1,298 cr in the company, thereby eliminating any chance of free cash flow. The company had a negative free cash flow of about ₹507 cr over FY2011-2020.

Filatex India Ltd had to raise debt of about ₹640 cr to fund its capital expenditure requirements. Total debt of the company increased from ₹81 cr. in FY2011 to ₹720 cr. in FY2020. In addition, it raised about ₹100 cr from equity issuances in the last year so that it could make the investments needed for its sales growth aspirations.

An investor may read our detailed analysis of Filatex India Ltd in the following article: Analysis: Filatex India Ltd

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 a difficult time to tide over the crisis.

Looking at the above situation, it is clear that Filatex India Ltd does not have a significant margin of safety built into its business model.

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

Should we reject companies with a negative Free Cash Flow straightaway?

From the above discussion, an investor would notice that the companies with a positive FCF come across as the ones with a good and stable financial position. However, it does not mean that an investor should reject any company with a negative FCF straightaway even if other parameters show that it has a fundamentally sound business model. The answer is, No!

This is because when an investor looks at the formula of FCF (= CFO – Capital Expenditure), then she would notice that instead of a weak CFO, a large capital expenditure (Capex) may be the reason for negative FCF. Moreover, a large capex may be a result of excellent investment opportunities available for the company in its business. As a result, the company may be striving to grow its business fast to capitalize on the available opportunities.

In our attempt to analyse all the companies listed on India stock exchanges, when we looked at the financial performance of more than 2,800 companies above a market capitalization of ₹10 cr, then we came across many companies which had grown their business significantly and as a result, they had a negative free cash flow. At the same time, these companies rewarded their shareholders by the way of a significant increase in their share price because they kept the debt levels within control and improved their business strength.

Read: What I learnt from brief analysis of 2,800 Companies

7) Many large companies keep rewarding shareholders by way of increase in stock market price despite nil or negative free cash flow:

During the analysis of many large companies, I noticed that the stock price of these companies had witnessed a significant increase over the last 10 years where these companies had nil or negative free cash flow. In many cases, these companies had resorted to funding this cash flow gap by taking additional debt. However, in almost all the cases, the debt raised was small and within easily serviceable limits.

An investor would appreciate that the final investment decision by any investor is a result of a combination of all the parameters like financial, business, management and valuation analysis. Therefore, even in the case of companies with a negative FCF, if the investor notices that they have strong performance on other parameters and their debt level is under control, then she may look at these companies for investment instead of rejecting them straight away due to negative FCF.

After reading our entire discussion, an investor would realize that there are two major sources of a margin of safety in a stock investment, which can help investors 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) after 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 a 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 a margin of safety in the purchase price, do not have a high margin of safety in the business.

Therefore, it becomes critical for the investor to search for companies, which have a 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 a significant amount of wealth through stock markets.

Such companies, which have a combination of a 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!

Readers’ queries about calculating the Margin of Safety

Hi, how do you measure the margin of safety if you do not calculate the value of the company?

Regards

Author’s Response:

Thanks for writing to me!

I use the concept of margin of safety explained in the following article: How to do Valuation Analysis of a Company

“The concept of MoS by Benjamin Graham is based on EY. Graham says that the higher the difference between EY and G-Sec/Treasury Yield, the safer is the stock investment.

To illustrate, suppose the investor buys a stock of company ABC Ltd at INR 100. If EPS of ABC Ltd is INR 10 then P/E ratio would be 10 and the EY would be 1/10 or 10%. As current G-Sec yield is 8%, ABC Ltd is a good investment. Suppose, after the investor buys ABC stock, its price falls and become INR 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 ABC stock as it yields 20% against G-Sec yield of 8%. This new demand for ABC stock will increase its stock price and limit the downfall. Herein, Graham says that higher the difference between EY and G-Sec/Treasury yield, higher is the Margin of Safety.”

Regards,

Why would a company increase debt in spite of a positive free cash flow (FCF) and a high SSGR

Hi Sir,

I have a query.

I am curious to know under what circumstances a company will add debt in a particular financial year when it has positive free cash flow (FCF). Self-sustainable growth rate (SSGR) has been consistently higher than 10-year sales growth. The company has higher cash & investment at the end of the financial year versus at the start of the financial year. The working capital cycle is 62 days excluding payables, which is not high. It has a positive net cash flow at the year-end & most surprisingly has higher cash & equivalent at the end of the year versus the start of the year.

It does not just make sense to add debt.

I was looking at the financials of the company (I have to start in-depth analysis) & got curious since as per your teachings this company defies the logic that in case of self-sustainable growth rate (SSGR) being higher than sales growth & a positive free cash flow (FCF), the company should be debt-free & on the contrary it is adding debt.

I am befuddled. Your inputs will be valuable as I am seeking a general opinion that under what circumstances will the company do this.

Best Regards,

Author’s Response:

Hi,

Thanks for writing to us! We are happy to see that you are doing your own equity analysis and spending time and effort to understand different concepts.

It might be a case that the company is investing money in other subsidiaries, related parties etc., which is consuming the free cash flow (FCF) generated by the company. The point to note here is that in the data provided by Screener, the money infused in subsidiaries/non-current investments is classified under “investments” and therefore, is not deducted from CFO while calculating free cash flow (FCF) as capital expenditure.

Advised reading: Free Cash Flow: A Complete Guide to Understanding FCF

Alternatively, the company may be accumulating cash in order to go for any acquisition. This is because a buyer who is able to show the readily available cash to the seller usually gets a favourable deal from the seller.

Ideally, the companies in the scenario described by you should not have increasing debt. Such companies are expected to have low/negligible debt or a declining trend in debt year on year. However, to have any firm opinion about any company showing increasing debt despite having a positive free cash flow (FCF) and a higher self-sustainable growth rate (SSGR), it is advised to do a detailed analysis of the company.

Further advised reading: Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company

All the best for your investing journey!

Regards,

Dr Vijay Malik

Impact of changing interest rates on Margin of Safety

Q 1:

Hi Vijay Malik sir,

I find your articles very useful. Thank you for doing such a great job of contributing to the investor community.

My query is relating to the Margin of Safety (MoS) principle, wherein it says that ‘higher the difference between the Earnings Yield (EY) and 10-year G-sec Yield, higher is the margin of safety’. So, you advise the investors to buy stocks that have PE<10 with sound fundamentals. This was the case when you started writing the blog when the 10-year G-sec yield was around 8%. But in today’s economic scenario in India where the 10-year G-sec yields have come down to ~6.23%, should an investor increase his PE parameter since a slightly higher PE parameter of say ‘PE<12’ while screening the prospective companies for detailed analysis would still offer a good margin of safety (as EY = 1/12 i.e. 8.33%) when compared to 10 years G-sec yield of ~6.23%.

I would like to receive your views regarding this query, sir.

Thanks in Advance.

Q 2

Read: Final Checklist for Stocks Analysis

Thank you, Sir, for explaining in such a simplified manner.

I have one doubt regarding PE to be below 10. G-sec yield, now, is around 6.24% based on which PE comes around 16. Should we not take PE<16 criteria as having a sufficient margin of safety? Or am I missing something?

Author’s Response:

Hi,

Thanks for writing to me! I am happy that you found the article useful.

You are right that the benchmark P/E ratio for comparison/arriving at the margin of safety keeps on changing as per the interest rate scenario in the economy. In low-interest rate scenarios, the benchmark P/E ratio increases when compared to scenarios of high-interest rate.

You may read more about my thoughts on the appropriate P/E ratio to be paid for stocks in the following article:

Read: 3 Principles to Decide the Ideal P/E Ratio of Stocks

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr Vijay Malik

Use of CFO instead of revenue in calculation of Margin of Safety

why do we use FCF/ CFO instead of FCF/ revenue as a ratio to gauge its ability to generate free cash flow? Which one is the better take?

Thank you.

Author’s Response:

Hi,

Thanks for writing to me!

We use FCF/CFO as both factors relate to cash. Comparing FCF to revenue would not be appropriate as revenue is an accrual accounting concept, which might not represent the actual cash received by the company in a period of time.

Regards,

Vijay

Does expect future sales growth provides any margin of safety?

Hi Vijay,

As always great article. Thanks for sharing wisdom in such simple and easy to understand way.

I have a doubt here which arose as I was reading an interesting article from Anil Tulasiram who did a great study on the correlation of growth and returns.

So my question is how important role does growth play in the margin of safety (MoS)?

I understand that Self Sustainable Growth Rate (SSGR) covers it well, but how can we anticipate future growth of a company and build it in a margin of safety when it is doing huge capital expenditure (capex) which will give FCF in future down the line.

Thanks

Author’s Response:

Hi,

Thanks for writing to me!

We do not use future growth, cash flow projections/DCF in my analysis. SSGR uses the past performance data to have an idea of the potential growth that a company is capable of generating. Whether the company will achieve this growth rate (SSGR) or not, will depend upon the management using its resources well.

Read: Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company

We do not advise investors to use any future projection in the assessment of margin of safety (MoS). Multiple times, it has been proved in the markets that future projections do not hold true and the MoS which supposedly existed on excel did not prove right in the real world.

Hope it clarifies your doubt.

All the best for your investing journey!

Regards,

Vijay

Underlying Principle of Margin of Safety in a Stock

Thanks for your answer. I understood the way you calculate the margin of safety. I mean that if you do not measure the safety margin, for example, a public company traded at ₹80 and is worth ₹100, therefore, it has a safety margin of 20%.

You measure the difference between the dividend yield and the G-SEC yield and then say that it has “more or less” margin of safety, but not 20%, 30%, 40% etc. safety margin, a specific number.

Regards.

Author’s Response:

Hi,

You got it right that I do not assign any value (say fair value) to the stock and therefore, do not find the margin of safety by comparing how current market price stands vis-a-vis the fair value.

As rightly mentioned by you, I look at how attractive the earnings yield is in relation to the fixed income returns.

Having said that I do not mean that every stock with high earnings yield (i.e. low P/E) is a good stock to invest. An investor needs to analyse low P/E stocks carefully, to avoid investing poorly performing companies, which deserve low P/E ratios.

Regards,

Vijay

I have shared the learning that I have had in my investing journey related to the margin of safety, which I believe 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 investment 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

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.

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2 thoughts on “Margin of Safety in Stock Investing: A Complete Guide

  1. I think that the SSGR formula is wrong because you have assumed that NFAT remains the same in year S0 and S1 while deriving and hence this formula is only a special case. Instead of SSGR, you should look at the operating margin and the capital turnover ratio to have a view of the return on invested capital and whether it is higher than the cost of capital because growth is valuable only when it is increasing the value of the company to the shareholders. And return on invested capital along with the reinvestment rate will give you an idea of the growth rate in earnings. Now, even if sales growth is lower than the earnings growth it might be due to margin expansion or operating leverage or both and if sales growth is more than the earnings growth rate for the period under consideration then it is pure gravy and is likely to moderate as the company becomes a mature company. I agree with you on your contention that sales growth less than earnings growth ( SSGR as you may like to call it ) is like keeping the gun powder dry for an emergency. Thank you! 🙂

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