Principles of Value Investing: Margin of Safety

Timing the Equity Markets is a very tricky issue: otherwise how would one explain a near 100% gain in Sensex and Nifty levels from their March 2009 lows. Understanding the principles of 'Value Investing' propounded by Benjamin Graham and Warren Buffet will help investors earn a decent profit on their equity investments, despite the volatility on the markets. One of the underlying principles of Value Investing is 'Margin of Safety'.

In simple terms Margin of Safety (safety margin) is the difference between the intrinsic value of a stock as compared to its market price. The term margin of safety was coined by Benjamin Graham & David Dodd in their seminal 1934 book, Security Analysis. Using margin of safety, one should buy a stock when it is worth more than its price on the market. This is the central thesis of value investing philosophy which espouses preservation of capital as its first rule of investing. Benjamin Graham suggested to look at unpopular neglected companies with low P/E (Price to Earnings) and P/B (Price to Book Value) ratios. As fair value is difficult to accurately compute, the margin of safety gives the investor room for error, and protects the investor from both poor decisions and downturns in the market.

Valuation is the process of determining the current worth of an asset or company. There are many techniques that can be used to determine value, some are subjective and others are objective. An analyst valuing a company may look at the company's management, the composition of its capital structure, prospect of future earnings, and market value of its assets. Benjamin Graham defines "Margin of Safety" as the price at which a share investment can be bought with minimal downside risk. This concept is very important for investors, as value investing can provide substantial profits once the market inevitably re-evaluates the stock and its price moves closer to fair value. It also provides protection on the downside if things don't work out as planned and the business falters.

Analysing the current global scenario, nothing has changed so dramatically between March 09 and June 09 to warrant such euphoria on the markets. Some stocks have gone past their intrinsic value and do not merit investment at current levels, rather it would be worthwhile to book some profits at these levels.