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Benjamin Graham's view of Margin of Safety

Dec 5, 2004

Benjamin Graham, frequently referred to as "the father of value investing" defines margin of safety as:

earning power of the company - return on long-term risk-free bonds

Where a company's earning power is calculated by taking the company's average earnings per share over the last several years, and dividing this by the share price. For example, suppose Jack's Furniture Company (not a real company) trades at $17.5 per share, and suppose its earnings per share over the last several years have been:

$1

$1.2

$1.3

$1.65

$1.75

From these results, it looks like this company is growing at approximately 15% per year and is trading at a P/E ratio of 10. Graham, however, would suspect that the company's earnings only grew because of temporary factors. For example, perhaps the economy is doing particularly well at the moment, leading people to purchase more furniture than usual. Graham might expect that in the future, the company's earnings will fall a to lower level.

He would likely say, the earning power of the company is the average of the company's earnings over the last several years, or:

1 + 1.2 + 1.3 + 1.65 + 1.75
--------------------------- = $1.38 per share.
5

Dividing $1.38 into the share price of 17.5, we get an earnings yield of 7.8%.

If long term treasury bonds are returning 5%, the company is trading at a margin of safety of 7.8% - 5%, which is 2.8%. This means, the company's earnings yield is 2.8 percentage points higher than is necessary for the stock to perform as well as risk-free bonds. If the company performs worse than we expect, and the company's earning power turns out to be only $0.88 per share, the return on the stock will likely be roughly equal to the return on 30-year treasuries. So, according to Graham's theory, Jack Co is likely a better investment than long-term bonds, even if the company's earnings fall significantly.

This concept of "margin of safety" is quite conservative, but that doesn't make it useless. It might be worth considering.

For more information on this approach, see chapter 20 of the Graham's classic value investing book, The Intelligent Investor.