Intrinsic Value and the Margin of Safety: What Is it all About?

The margin of safety principle is a fundamental part of value investing. Indeed, you could go so far as to say that without understanding this principle, it is not possible to follow a value strategy.

That being said, just by buying a stock that is trading below book value could qualify as buying with a margin of safety. However, as most experienced value investors will tell you, it is often not enough just to find the stocks trading below book value. Following this strategy can often lead you into value traps. There is usually a reason why stocks are trading below their book value per share and if you do not understand why, you could have a very negative surprise further down the line.

If a company is earning less that its cost of capital, then its shares deserve to trade below book value, as the firm is technically shrinking.

Placing a Number on Value

Calculating a companyAAAs intrinsic value or producing an estimate of intrinsic value is essential if you want to avoid falling into a value trap.

Intrinsic value is an estimate of the value of a particular business based on the value of the firmAAAs cash flows. By focusing on cash flows alone, the value investor protects themselves to some extent from falling into disastrous value traps.

Warren Buffett ( Trades , Portfolio ) provides one definition of intrinsic value in BerkshireAAAs OwnerAAAs Manual. He writes:

The brilliant Aswath Damodaran takes this definition of intrinsic value a step further, stating that:

It is fundamental to understand the difference between intrinsic value and book value. Moreover, it is vital to understand that book value and intrinsic value are not related and in some cases, book value can actually be higher than intrinsic value. Once again, BerkshireAAAs OwnerAAAs Manual gives an excellent example of why valuing a business like Berkshire Hathaway in the early years was more complicated than just computing the companyAAAs net asset value.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.