“confronted with a challenge to distill the secret of sound investing into three words, we venture the motto, Margin of Safety” Benjamin Graham, The Intelligent Investor
Of all the concepts that a value investor holds dear, intrinsic value and the “margin of safety” are the most sacred. These ideas form the bedrock of what Benjamin Graham set out over 80 years ago in his book “Security Analysis”, without which stock research would still be stuck in the dark ages. Intrinsic value provides a solid framework for investors to determine if a stock is overvalued or undervalued.
While many people like to make a great distinction between value investing and other types of investing, Warren Buffett would argue that all investing is value investing. If you don’t have a sense for the value of what you’re buying then it’s simply called guessing (or perhaps more politely ‘speculation’).
Intrinsic Value
Intrinsic value as a concept is not difficult to understand – it merely represents the future cash flows of a company discounted back to a present value. But as Buffett points out, just because it can be defined easily, doesn’t mean that it can be calculated easily. Benjamin Graham himself described intrinsic value as an “elusive concept”.
Intrinsic value will be subject to a wide margin of error because our forecasts about the future are subject to a wide margin of error. Experience tells us we simply cannot forecast the future with much precision. This is one reason why Buffett sticks to stable businesses, where future cash flows can be estimated with at least some degree of confidence. Conversely, he stays away from businesses where cash flows cannot be easily forecast. Consider a technology hardware company such as Apple. If Apple continues to release highly innovative and successful products, cash flows could be far higher in 3 years time than they are today. But if they lose out to other products over time, the cash flows of Apple could be far lower. No doubt Apple is a great company, but the chances of correctly forecasting cash flows 3 years from now are very slim.
