Intrinsic Value and Margin of Safety

Maximizing Gains while Minimizing Risks

When I first started investing, my approach was simple: find good businesses and invest in them, regardless of their current market price. This seemed logical at the time — after all, if the company is solid, wouldn’t it be a good investment? However, as I gained more experience, I realized that the price you pay for a stock is just as important as the quality of the business itself. Even the best businesses can be bad investments if you overpay for them.

This is where the concepts of intrinsic value and margin of safety come into play. Let’s dive deeper into these ideas.

Intrinsic value is the actual worth of a stock, based on an analysis of its underlying business. For simplicity, let’s consider the 200-day Simple Moving Average (SMA) as a proxy for intrinsic value. The 200-day SMA is the average price of the stock over the past 200 days and is often used by investors to gauge the long-term trend of a stock’s price.

If the current market price of the stock is below the 200-day SMA, it might indicate that the stock is undervalued, and if it’s above, the stock might be overvalued. Using the 200-day SMA as a benchmark, you can assess whether the stock is trading at a price that’s fair compared to its recent history.

Margin of safety is the buffer or cushion you give yourself when buying a stock below its intrinsic value — in this case, the 200-day SMA. This buffer protects you from potential errors in your analysis or unforeseen market conditions.

For example, if the 200-day SMA of a stock is ₹1,000 per share, but the current market price is ₹800, there’s a margin of safety of 20%. This margin of safety reduces your risk because you’re buying the stock at a discount to its recent average price.

Let’s take Infosys (NSE: INFY), a large-cap stock, as an example. Infosys is a well-established IT services company in India with a strong track record, reliable earnings, and good growth prospects.

Assume that the 200-day SMA of Infosys is ₹1,700 per share. This means that over the past 200 days, the average price of Infosys has been ₹1,700. Now, let’s say the current market price of Infosys is ₹1,500 per share. In this case, Infosys is trading at a 12% discount to its 200-day SMA.

This gives you a margin of safety because you’re purchasing the stock at a price lower than its recent long-term average. This discount acts as a cushion, protecting you if the stock price dips further or if your assumption about its future prospects turns out to be too optimistic.

By focusing on intrinsic value (using the 200-day SMA as a simple estimate) and margin of safety, you can make more informed investment decisions. Instead of buying good companies at any price, you aim to buy great companies at a fair or discounted price. This approach can help protect your investments from downturns and increase your chances of making a profit in the long run.

Understanding intrinsic value and margin of safety is crucial in investing. Even a simple method like using the 200-day SMA can provide valuable insights into whether a stock is fairly priced. By combining this with a margin of safety, you can reduce your investment risk and improve your chances of success. Remember, “Price is what you pay, value is what you get.” By paying attention to both, you set yourself up for a more successful investing journey.

If you loved this story, please feel free to check my other articles on this topic here: https://ankit-rathi.github.io/tradevesting/

Ankit Rathi is a data techie and weekend tradevestor. His interest lies primarily in building end-to-end data applications/products and making money in stock market using Tradevesting methodology.