Tag Archives: Margin of Safety

Warren Buffett’s top 10 rules for success

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Billionaire investor Warren Buffett, “Oracle of Omaha, has a set of rules, principles and philosophies when it comes to making a decision, investing, managing the business and also building success in life. And his success principles can be summarized with the top 10 rules below.

“Don’t be afraid to give up the good to go for the great.” – John D. Rockefeller.

  1. Find Your Passion. Almost every successful person agrees that finding and following your passion is something important if you want to produce an amazing result in life. There is no guarantee that you will be able to find your passion in your first job, but you have to keep digging until you find it. Steve Jobs once gave a commencement speech at Stanford University and said: “Your work is going to fill a large part of your life, and the only way to be truly satisfied is to do what you believe is great work. And the only way to do great work is to love what you do. If you haven’t found it yet, keep looking. Don’t settle. As with all matters of the heart, you’ll know when you find it.” The only way you can produce outstanding work is through passion. Without passion, you will do things with the half-hearted approach and there is no way you can become the best this way. Thus, find your passion, do what you love and you will be able to produce amazing success in life when you do.
  2. Hire Well. If you want to be a billionaire, there is no way you can go about it all by yourself, you need to have a great team. And to have a great team, you must learn to hire well. Always remember that you cannot succeed alone in this world. You need other people’s help to bring you the success you want. And your people will be your greatest assets. According to Buffett, he emphasizes on 3 qualities when he hires, and they are, integrity, intelligence, and energy. Buffett also said that out of those 3 qualities, integrity comes first. He also jokingly said that you do not want to hire someone who has no integrity but has a lot of intelligence and energy. Integrity comes first. Without integrity, other qualities do not matter much
  3. Don’t Care What Others Think. It is important not to care what others think. And this is extremely important because you do not want to take into consideration what other people have to say, because you will be influenced and will never be able to hold onto your investing principles. If you was to listen to what others said, he will become like most people, living an average life. When it comes to achieving the success you want and living your dreams, there will be people telling you that achieving what you want is impossible and simply suggest you get a real job. Never listen to the naysayer. You have to follow your heart and do what you think is right. Circle of Competence” is what he has used as a way to focus his investment on only operating in areas he knew best. The concept basically explains that every one of us has developed useful knowledge on certain areas, and what we need to do is to operate in these areas that we are good at. When you care too much about what others think and say about you, you will restrict your own freedom and it will prevent you from living your best life according to your own terms.
  4. Read, Read, Read – The more you read, the smarter you will get and the more knowledge you will gain. When you become more knowledgeable, you will be able to make a better decision that will lead you to the success you want. Highly successful people are great readers and you have to adopt the same habit. Commit to reading every single day. If you find that you are busy and do not have much time to read, start small and read for 15 minutes a day. If possible, go for more. Read at least an hour a day. You can wake up earlier and make time for reading or you can make good use of your commuting time for reading. You need to be a lifelong learner and when reality changes, you need to change and adjust you strategy.
  5. Have A Margin of Safety – The concept of “margin of safety” is easy to understand, and requires great discipline and patience.  Buffett uses the metaphor of driving across a bridge to explain this concept. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. You have a margin of safety of 20,000 pounds. And when it comes to investing, you will never buy a business worth $50 million for $60 million. You will buy the business worth $50 million at a price below that to ensure there is a margin of safety. This concept is essential in the principle of value investing. It helps investors make better and wiser decisions before jumping into buying a stock. When an opportunity is presented, evaluate using the margin of safety concept before you decide.
  6. Have A Competitive Advantage – Buffett said that capitalism is all about somebody coming in and trying to take the castle. And what you need for your castle is a moat to protect your castle from your enemies. In the business world, your business needs to have a durable competitive advantage to survive for the long term. Today, the competition is tough and people can copy exactly what you do and produce the same product and put you out of business. This is why having a competitive advantage to protect your business like a moat protecting a castle is important. Buffett said that he will invest in businesses that have a competitive advantage because he wants to make sure that the business will still be around after years down the road.
  7. Schedule Your Personality – Build your business around your personality. In order to succeed in what you do; you must find your pace and your sweet spot so that you will enjoy your work and perform at your best. Buffett loves reading and he chooses to read to improve his knowledge, and then he acts as the strategist and manages his business from backstage. He organizes his business according to his personality. If you love drinking a cup of coffee before you start your work, do it. Organize your workspace according to your own taste, that will make you more productive. The key is to play to your strength and personality so that you can become the best at what you do.
  8. Always Be Competing – Buffett believes that one of the most common business killers is complacency. When people fall into their comfort zone and fail to improve their competitiveness, their businesses will eventually fail or be taken over by the competitor. And to stay ahead of the game, you must always be competing. Every business has problems in every industry. The key to making a business thrive is its ability to compete and stand out from the rest. And this is why you invest in a business that continues to thrive because you are always competing. Therefore, never rest on your laurels, keep competing, keep improving and innovating in your business.
  9. Model Success – There is no way you can succeed alone in this world. If you want to achieve great success in life, you need others. and, you must model other successful people, or better yet, get yourself a mentor. Take a look in the sports industry, every outstanding and professional athlete has a coach. Tiger Woods has a coach. Michael Jordan has a coach. You need a coach to guide you on the journey to success. Your coach can also remind you of your goals and inspire you to do your best. In business, having a mentor is said to be one of the most important keys to success. Success leaves clues and what you need to do to produce a great result is to model the success of others. Learn and study from others, and then learn, grow and improve yourself to become better.
  10. Give Unconditional Love – Finally, the most powerful force in this world is unconditional love. And everyone who wants to achieve success in life gives unconditional love.
  11. Bonus: Power of Compounding – “The power of compounding your money inside a successful business for a long time is nearly unmatched in capitalism.”

The final rule for success by Warren Buffett has a lot to do with your personality and beliefs. Being a philanthropist, Buffett believes in helping society and giving back to the world. This could be the reason why he has been so successful. He is always looking to help and to give, rather than to take. When you operate in a giving and grateful mindset, you will put your customers first, and this is what makes a business enterprise thrive

Source:  https://www.thewisdompost.com/billionaires/warren-buffett/warren-buffetts-top-10-rules-success/1575

Margin of Safety

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“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” ~ Seth Klarman

Berkshire Hathaway CEO and Chairman, Warren Buffett, is known for his value investing approach, which involves finding companies that are undervalued by the market and investing in them for the long term. To invest like Warren Buffett, there are a few things you need to know.

  • First, you need to have a clear understanding of what value investing is and how it works.
  • Second, you need to be patient and be willing to hold onto your investments for the long term.
  • Third, you need to have the discipline to stick to your investing strategy even when the market is going against you.

When deciding on how to invest in a company, the first step is to determine its worth or intrinsic value. According to Warren Buffett, the best companies to buy are those that are inexpensive to buy. His investment strategy is based on a few simple principles:

  • Buy quality companies that have a competitive advantage (moat),
  • Buy them at a reasonable price with a margin of safety, and
  • Hold them for the long term.

These principles of margin of safety have helped Buffett generate incredible returns over his career. Margin of safety is a strategy that involves investing only in securities at a significantly lower intrinsic value than their market price.

The margin of safety (MOS) allows investors to avoid overpaying for an investment or asset, and it protects investors from the potential of loss if the market price of the asset falls. Buffett has said that the margin of safety is the key to his investing success.

The margin of safety is a measure of how much room there is between the price of the stock and its inherent value. The wider your margin of safety, the less likely it is that overly optimistic valuation inputs will harm your investment.

Value investing is the process of making investment decisions using margin of safety. It is critical for value investors to find a high-quality, easy-to-understand company with good management priced below its intrinsic value.

The purpose of using a margin of safety in buying is twofold.

  • If your investment does not grow as quickly as you originally anticipated, you may be forced to make more conservative investments in your portfolio. If your estimates are correct, you will be able to achieve a better rate of return over time due.
  • If you purchased the investment at an extremely low price.

Discounted cash flow (DCF) is a method of valuing a company or asset using the principles of time value of money.

The objective of DCF is to find the value of an investment today, given its expected cash flows in the future. One popular way to value a company is using the discounted cash flow (DCF) method. This approach discounts a company’s future expected cash flows back to the present day, using a required rate of return or “hurdle rate” as the discount rate. The idea is that a company is worth the sum of all its future cash flows, discounted back to the present.

The DCF formula is: Value of Investment = Sum of (Cash Flow in Year / (1 + Discount Rate)^Year)

The “discount rate” is the required rate of return that an investor demands for investing in a company. This rate is also known as the “hurdle rate.” There are two ways to calculate the discount rate.

There are two ways to calculate the discount rate.

The first is the weighted average cost of capital (WACC). This approach considers the cost of all the different types of capital that a company has, including debt and equity.

The second way to calculate the discount rate is the discount rate for equity. This approach only considers the cost of equity, which is the return that investors demand for investing in a company.

Once the discount rate is determined, the next step is to estimate the cash flows that a company is expected to generate in the future. These cash flows can come from a variety of sources, including operating income, investments, and financing activities. After the cash flows have been estimated, they need to be discounted back to the present using the discount rate.

The present value of the cash flows is then the sum of all the future cash flows, discounted back to the present.

“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may want a little larger margin of safety.” ~ Warren Buffett

References:

  1. https://www.merchantshares.com/margin-of-safety-the-key-to-warren-buffetts-investing-success/
  2. https://www.merchantshares.com/the-dcf-method-of-valuing-a-company/
  3. https://www.merchantshares.com/how-to-win-warren-buffett-39/

Peter Lynch’s five rules to investing

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“If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train—and succumbing to the social pressure, often buys.” Peter Lynch

Legendary American investor Peter Lynch shared five rules everyone can follow when investing in the stock market.

Within his 13-year tenure, Lynch drove the Fidelity Magellan Fund to a 2,800% gain – averaging a 29.2% annual return. It is the best 20-year return of any mutual fund in history. He is considered the greatest money manager of all time, and he beat the market for so long through buying the right stocks.

No one can promise you Lynch’s record, but you can learn a lot from him, and you don’t need a billion-dollar portfolio to follow his rules.

Lynch’s five rules for any investor in the stock market are listed below.

1. Know what you own

The most important rule for Lynch is that investors should know and understand the company they own.

“I’m amazed at how many people that own stocks can’t tell you, in a minute or less, why they own that particular stock,” said Lynch.

Investors need to understand the company’s operations and what they offer well enough to explain it to a 10-year-old in two minutes or less. If you can’t, you will never make money.

Lynch believes that If the company is too complicated to understand and how it adds value, then don’t buy it. “I made 10 to 15 times my money in Dunkin Donuts because I could understand it,” he said.

2. Don’t invest purely on other’s opinions

People do research in all aspects of their lives, but for some reason, they fail to do the same when deciding on what stock to buy.

People research the best car to buy, look at reviews and compare specs when buying electronics, and get travel guides when travelling to new places – But they don’t do the same due diligence when buying a stock.

“So many investors get a tip on a stock travelling on the bus, and they’ll put half of their life savings in it before sunset, and they wonder why they lose money in the stock market,” Lynch said.

He added that investors should never just buy a stock because someone says it is a great buy. Do your research.

3. Focus on the company behind the stock

There is a method to the stock market, and the company behind the stock will determine where that stock goes.

“Stocks aren’t lottery tickets, there’s no luck involved. There’s a company behind every stock; if a company does well, the stock will do well – It’s not complicated,” Lynch said.

He advises that investors look at companies that have good growth prospects and is trading at a reasonable price using financial data such as:

• Balance Sheet – No story is complete without a balance sheet check. The balance sheet will tell you about the company’s financial structure, how much debt and cash it has, and how much equity its shareholders have. A company with a lot of cash is great, as it can buy more stock, make acquisitions or pay off its debt.

  • Year-by-year earnings growth
  • Price-to-earnings ratio (P/E) – relative to historical and industry averages.
  • Debt-equity ratio
  • Dividends and payout ratios
  • Price-to-free cash flow ratio
  • Return on invested capital

4. Don’t try to predict the market

Trying to time the market is a losing battle. One thing to keep in mind is that you aren’t going to invest at the bottom. Buy stocks because you want to own the business long-term, even if the share price decreases slightly after you buy.

Instead of trying to time the bottom and throwing all your money in at once, a better strategy is gradually building your stock positions over time.

This approach spreads out your investments and allows you to buy into the market at different times at varying prices that ideally balance each other out versus investing one lump sum all at once.

This way, if you’re wrong and the stock continues to fall, you’ll be able to take advantage of the new lower prices without missing out.

“Trying to time or predict the stock market is a total waste of time because no one can do it,” Lynch said.

Corollary: Buy with a Margin of Safety: No matter how careful an investor is in valuing a company, she can never eliminate the risk of being wrong. Margin of Safety is a tool for minimizing the odds of error in an investor’s favor. Margin of Safety means never overpaying for a stock, however attractive the investment opportunity may seem. It means purchasing a company at a market price 30% or more below its intrinsic value.

5. Market crashes are great opportunities

Knowing the stock market’s history is a must if you want to be successful.

What you learn from history is that the market goes down, and it goes down a lot. In 93 years, the market has had 50 declines; once every two years, the market declines by 10%. of those 50 declines, 15 have declined by 25% or more – otherwise known as a bear market – roughly every six years.

“All you need to know is that the market is going to go down sometimes, and it’s good when it happens,” Lynch said.

“For example, if you like a stock at $14 and it drops to $6 per share, that’s great. If you understand a company, look at its balance sheet, and it’s doing well, and you’re hoping to get to $22 a share with it, $14 to $22 is terrific, but $6 to $22 is exceptional,” he added.

Declines in the stock market will always happen, and you can take advantage of them if you understand the company and know what you own.

References:

  1. https://dailyinvestor.com/finance/1921/peter-lynchs-five-rules-to-investing/

Margin of Safety

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“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger the margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.” Warren Buffett

Billionaire investor Warren Buffett, Chairman and CEO, Berkshire Hathaway, said, “The three most important words in investing are margin of safety.” Margin of Safety is a measure of how “on sale” a company’s stock price is compared to the true value of the company. You need to be able to determine the value of a company and from that value determine a “buy price”. The difference between the two is the margin of safety.

Effectively, margin of safety means you pay less for an asset than what it’s intrinsically worth. It means to buy $10 dollar bills for $5 dollars. That’s the secret to great and successful investing. The margin of safety is the difference between the intrinsic value of a stock and the current market price of the stock. The intrinsic value of an asset is its actual value, that is, the present value of the asset found by calculating the total discounted future income it’s expected to generate.

The intrinsic value is calculated based on the 10 year discounted free cash flow (DFCF).

In other words, if the stock price of a company is below the actual value of the free cash flow (income) and assets of a company, the percentage difference is the Margin of Safety.  This is the discounted price at which you are buying a share in the company.

A higher margin of safety will reduce your investment risk. If an investor can buy a stock below its intrinsic value, the potential for a bad outcome, risk, is usually lower.

Warren Buffett likes a margin of safety of over 30%, meaning the stock price could drop by 30%, and he would still not lose money. Margin of safety is only an estimate of a stock’s risk and profit potential.

Buffett determines margin of safety by estimating the current and predicted earnings from a company from today and for the next ten years.  He then discounts the cash flow against inflation to get the current value of that cash.  This is the Intrinsic Value of the company. He bases intrinsic value on the discounted future free cash flows. He believes cash is a company’s most valuable asset, so he tries to project how much future cash a business will generate.

Margin of Safety is a value investing principle strategy. If the total value of all shares of a company is 30% less than the intrinsic value of that company, then the margin of safety would be 30%. In other words, if the stock price of a company is below the actual value of the cash flow and assets of a company, the percentage difference is the Margin of Safety.  This is the discounted price at which you are buying a share in the company. Most value investors believe that the higher the margin of safety, the better.  In reality, a margin of safety between 30% and 50% is reasonable.

The Margin of Safety is the percentage difference between a company’s Fair Value per share and its actual stock price. If a company has profits and assets that outweigh a company’s stock market valuation, this represents a Margin of Safety for the investor. The higher the margin of safety, the better.

Margin of safety is only an estimate of a stock’s risk and profit potential. Most value investors believe that the higher the margin of safety, the better.  And, the larger the margin of safety, the more irrational the market has become. 

One of the keys to getting a great margin of safety is to understand that price and value is not the same thing. Price is what you pay for something, but the value is what you get.

The stock market rises about four out of every five years or about 80% of the time, according to Nick Murray. Said another way, the market only falls 20% of the time. You can fear that 20% or cheer for it.

No one ever got wealthy paying full price or top dollar for financial assets, according to Buffett. Most successful investors got that way buying assets that were distressed, out of favor, and therefore on sale. Unfortunately, few people see it that way. You need to take advantage of the sale during market selloffs and corrections when it occurs. Your money literally goes further because you can buy more share at lower prices that lead to market-beating returns later on.

If you want to make good long-term investment returns, you need to minimize your risk by purchasing companies selling at a significant discount to their intrinsic value due to market volatility. 

References:

  1. https://novelinvestor.com/10-lessons-learned-nick-murray/
  2. https://www.ruleoneinvesting.com/blog/how-to-invest/how-to-invest-margin-of-safety-the-growth-rate/
  3. https://www.liberatedstocktrader.com/margin-of-safety/

Intrinsic Value of a Company

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“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”  Warren Buffett

Intrinsic value is an important concept to evaluate the relative attractiveness of investments and businesses.

Intrinsic value can be defined as the discounted value of the cash that can be taken out of a business during its remaining life, explains investing guru Warren Buffett, Chairman and CEO, Berkshire Hathaway. It measures the value of an investment based on its current and future cash flows. Where market value tells you the current price per share other investors are willing to pay for an asset, intrinsic value shows you the asset’s value based on an analysis of its future cash flows and its actual financial performance.

Essentially, valuing a company intrinsically allows you to look analytically at a business and determine how much cash that business will generate over time, and then you discount the cash flows back to the present day.

Book value vs intrinsic value

In most cases, a company’s book value tends to understate its intrinsic value because many businesses are worth much more than their ‘carrying value’. The ‘carrying value’ is the original cost of an asset as reflected in a company’s books or balance sheet, minus the accumulated depreciation of the asset.

As a result, a company’s intrinsic value often exceed its book value, a result that proves capital was wisely deployed. In many cases, book value is not a reliable indicator of intrinsic value or a true representation of an asset’s fair value or market value. Thus, a company’s book value alone is somewhat meaningless as an indicator of its intrinsic value.

However, intrinsic value tend to be only effective on stocks that are stable and less volatile so that you can reliably valuate. If you see the book value growth and dividends all over the place, your estimates would be very uncertain.

You need 3 factors to determine a company’s intrinsic value:

  • Current free cash flow or owner’s earnings
  • Free cash flow growth rate over an eight to ten year period. Determine free cash flow growth rates by looking at past 5 year and 10 year growth rate.
  • Discount rate to discount future free cash flow to present day.

Discounted future cash flows

Cash taken out of a business in the future is not worth the same as it is today. If you had the money today you could invest it today. Money in the future is partly eaten up by inflation, but more importantly more uncertain if it is there at all.

The calculation of intrinsic value is not so simple. Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised.

To calculate owner earnings, or another way to look and to calculate free cash flow, one adds things back in such as depreciation, changes in working capital and such. Buffett feels that “owner’s earnings” more accurately reflects the actual cash flow that an owner receives.

Net present value for the ten years and your discounted terminal value for the 10th year we can calculate the intrinsic value.

When investing in a company, you first must determine the value of the company according to your estimates of discounted cash flow. You want the biggest difference between its intrinsic value (high as possible) and its market price which is the current price of the stock that is traded on the exchange (low as possible). Over time, you should expect the market value to intersect its intrinsic value.

When you arrive at an intrinsic value it will not necessarily match the current market value or price of the stock. In most cases you will find that there is a vast difference. You have potentially found a great company at a bargain and with a margin of safety. If the market price is much higher than the intrinsic value, it is also great. You can avoid the common mistake made by many retail investors of overpaying for a stock.

Knowing the value of a stock is perhaps the most desired skill. And in summary, intrinsic value is simply the discounted value of the cash that can be taken out of a business during its remaining life, according to Warren Buffett.

References:

  1. https://einvestingforbeginners.com/intrinsic-value-warren-buffett-aher/
  2. https://acquirersmultiple.com/2017/02/warren-buffett-how-to-calculate-intrinsic-value/
  3. https://corporatefinanceinstitute.com/resources/knowledge/accounting/carrying-amount/
  4. https://www.buffettsbooks.com/how-to-invest-in-stocks/intermediate-course/lesson-21/