One way to judge whether or not a stock is undervalued is to use the margin of safety approach.

Suppose you like Jack's Paint Company(not a real company) which earns $2 per share. It's a solid company with a strong, sustainable competitive advantage, but it doesn't have much growth potential. You think it will grow 3% per year (2% due to inflation and 1% due to population growth). Furthermore, the company has little debt and earns a return on equity of 30%. So we can predict that its free cash flow will be roughly 90% of its net income, or about $1.80 per share.

Now, suppose you expect the stock market to return 8% per year over the long term, and suppose the yield on 30 year treasuries is 7%.

In order to get an 8% return (and perform as well as the market) you'd need a 5% free cash flow yield (a 5% free cash flow yield + 3% in annual, long term growth will give a total return of 8%). Divide 1.8 by .05 and we get an intrinsic value of $36 per share.

Suppose the stock is trading at $25 per share. It is trading at 69% of your intrinsic value prediction (25/36 = 0.69 = 69%) which means that the stock is trading at a margin of safety of 31%. This means, even if the company doesn't perform as well as you expect, it is still likely to outperform the market. As long as the company's true intrinsic value turns out to be at least 69% of your estimate, it will perform at least as well as the market over the long term. If it does as well as you predict, it will outperform the market. To get a return of 7% (the risk free rate) we'd need a 4% free cash flow yield (7% return minus 3% growth gives us 4% free cash flow yield). 1.8/.04 = $45, so the value of Jack's Paint Company, relative to the risk-free rate, is $45. The margin of safety in the stock, relative to bonds, is (45-25)/45 or 44%.

Now let's estimate the return you will get by investing in the company. Its free cash flow yield is 7.2% (1.8/25 = .072) and its growth rate is 3%. So if you held the stock forever, you'd expect to get an annual return of about 10.2% (7.2 + 3 = 10.2). On the other hand, suppose that in five years, the stock becomes fairly valued relative to the overall market. Then, five years from now, its free cash flow yield will be 5%, rather than 7.2%. Projecting outward, we can predict that the company will generate 1.8*1.03^5 in free cash flow (initial free cash flow is $1.80 per share, which grows at 3% per year for five years). This gives us $2.09 in free cash flow. Dividing this by .05, we get a projected share price of $41.73. Now we have to add in dividends. Over the next five years, the company will have free cash flow (which it can pay out as a dividend) of $1.854 in the first year, growing at 3% per year until it reaches $2.09 in the fifth year. If you can earn an 8% return on those dividends, they will be worth $11.50 in five years. Add the $11.50 to $41.73 and you get a pre-tax annual return of [((41.73+11.50)/25)^(1/5) - 1] or 16.3%. So we see that, if you demand a high margin of safety, you are also increasing your discount rate. Conversely, if you increase the rate of return you require from a stock, you are also increasing your margin safety. This is why successful value investing defeats the risk-reward tradeoff. An undervalued stock offers a margin of safety, which reduces its risk; it also offers a higher expected return.

I should mention that certain companies should be purchased at a greater margin of safety than others. If you are predicting high growth for a company, you'll want to use a large margin of safety in order to account for the possibility that the expected growth won't materialize. And if you're investing in a business that has a weak competitive position, or a weak financial position, there is a greater risk that the company will underperform, and a greater margin of safety is necessary.

To summarize: the greater an investment's margin of safety, the higher its long term return will be. It will also be a safer investment. So an investor should always require a margin of safety.