Posted by L. C. Chong on October 15, 2013
http://lcchong.wordpress.com/2013/10/15/determination-of-margin-of-safety/
Margin of safety is a function of the following factors (Katsenelson 2007):
will work out. Some will do well, while others will not perform and will either deliver below-expected returns, break even, or worse—lose money. Based on this premise you set a high 30% first-year performance hurdle for each (average) new stock introduced to the portfolio. Your thinking goes—if I aim to achieve a 30% return from every stock, the worse half, the nonperformers, will offset the returns of the better half, the performers, and thus bring the return of the overall portfolio to the desired 15% a year.
However, once a stock’s margin of safety is exhausted (the stock appreciates to fair value), for the average stock to remain in the portfolio it should continue to deliver at least 15% of annual return from earnings and dividend payments (assuming that you don’t have more attractive—higher risk-adjusted return—opportunities on the horizon).
If you were looking for a 30 percent (initial required) annual return from an average individual stock introduced to the portfolio, dividends and stock appreciation driven by earnings growth and margin of safety (P/E expansion) are the generators of that return.
The expected return from an average-quality stock can be expressed as:
Dividend Yield + Earnings Growth + Margin of Safety = Initial Required Rate of Return
Subsequently, required (risk-unadjusted) margin of safety for an average-quality stock would look like this:
Risk Unadjusted Margin of Safety = Initial Required Rate of Return − Dividend Yield − Earnings Growth
The greater the dividend yield and/or expected earnings growth, the lower the margin of safety required for an average stock, as the earnings growth and dividend yield will be providing a greater portion of the return. We also know that not all companies are of average quality: higher-quality companies require a lower margin of safety and lower-quality companies require a higher margin of safety.
For example, a company has expected dividend yield and earnings growth rate of 1.5% and 10% respectively. You choose the required initial return as 30% (in reality, you choose a figure more than 30%; for me, I choose 35%). Calculation would look as follows:
Risk Unadjusted Margin of Safety = 30% − 1.5% − 10% = 18.5%
Our required margin of safety needs to be adjusted for the company’s risk factors:
Required Margin of Safety = Risk Unadjusted Margin of Safety × Business Risk Factor × Financial Risk Factor
Or:
Required Margin of Safety = (Initial Required Rate of Return − Dividend Yield − Earnings Growth) × Business Risk Factor × Financial Risk Factor
For example, let say the company has 0.9 and 1.0 for Business Risk Factor and Financial Risk Factor, calculation would look as follows:
Required Margin of Safety = 18.5% × 0.9 × 1.0 = 16.65%
To learn how I determine Business Risk Factor and Financial Risk Factor, please click here.
- Company’s quality—business and financial risks.
- Investor’s required rate of return for a stock.
- Company’s expected earnings growth rate.
- Company’s expected dividend yield.
will work out. Some will do well, while others will not perform and will either deliver below-expected returns, break even, or worse—lose money. Based on this premise you set a high 30% first-year performance hurdle for each (average) new stock introduced to the portfolio. Your thinking goes—if I aim to achieve a 30% return from every stock, the worse half, the nonperformers, will offset the returns of the better half, the performers, and thus bring the return of the overall portfolio to the desired 15% a year.
However, once a stock’s margin of safety is exhausted (the stock appreciates to fair value), for the average stock to remain in the portfolio it should continue to deliver at least 15% of annual return from earnings and dividend payments (assuming that you don’t have more attractive—higher risk-adjusted return—opportunities on the horizon).
If you were looking for a 30 percent (initial required) annual return from an average individual stock introduced to the portfolio, dividends and stock appreciation driven by earnings growth and margin of safety (P/E expansion) are the generators of that return.
The expected return from an average-quality stock can be expressed as:
Dividend Yield + Earnings Growth + Margin of Safety = Initial Required Rate of Return
Subsequently, required (risk-unadjusted) margin of safety for an average-quality stock would look like this:
Risk Unadjusted Margin of Safety = Initial Required Rate of Return − Dividend Yield − Earnings Growth
The greater the dividend yield and/or expected earnings growth, the lower the margin of safety required for an average stock, as the earnings growth and dividend yield will be providing a greater portion of the return. We also know that not all companies are of average quality: higher-quality companies require a lower margin of safety and lower-quality companies require a higher margin of safety.
For example, a company has expected dividend yield and earnings growth rate of 1.5% and 10% respectively. You choose the required initial return as 30% (in reality, you choose a figure more than 30%; for me, I choose 35%). Calculation would look as follows:
Risk Unadjusted Margin of Safety = 30% − 1.5% − 10% = 18.5%
Our required margin of safety needs to be adjusted for the company’s risk factors:
Required Margin of Safety = Risk Unadjusted Margin of Safety × Business Risk Factor × Financial Risk Factor
Or:
Required Margin of Safety = (Initial Required Rate of Return − Dividend Yield − Earnings Growth) × Business Risk Factor × Financial Risk Factor
For example, let say the company has 0.9 and 1.0 for Business Risk Factor and Financial Risk Factor, calculation would look as follows:
Required Margin of Safety = 18.5% × 0.9 × 1.0 = 16.65%
To learn how I determine Business Risk Factor and Financial Risk Factor, please click here.
http://lcchong.wordpress.com/2013/10/15/determination-of-margin-of-safety/
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