The recent drop in the stock market is opening doors to many opportunities. While some investors have felt the heat and decided to abandon ship, others may just find a perfect entry point to make new purchases.
In such volatile markets, wise use of a margin of safety becomes one of your best tools to make the right investing decision. Remember that during a correction, not all stocks are trading at discounts – some of them are simply bad investments and won’t recover.
The difference between catching a falling knife and buying a strong but undervalued company with a margin of safety is a thin line. The whole process behind analyzing a company is crucial and this is where valuation comes into play.
What is a Margin of Safety?
Before using the margin of safety, an investor must be able to evaluate the shares he is looking at. The goal is always to buy undervalued companies if you are looking to make strong profit. A good way to determine the value of a share is to use a dividend discount model. It is a relatively simple model and it’s easy to use. It will help you put a dollar value on a company and its ability to generate dividend payments.
The margin of safety happens once you have determined a value for a company XYZ. Let’s assumed you have made your calculations and you found that company XYZ’s shares should trade at $10. This is known as its “intrinsic value”. The “$10” is found based on your stock analysis and dividend discount model. Then, if the company stock is currently trading at $9, you benefit from a 10% discount; this is your margin of safety. In other words, while you think the company should be worth $10 a share, you can be wrong in your calculation up to $1 difference since the company is currently trading lower.
Warning, a wide margin of safety could mean two things:
#1 You found a great buying opportunity
#2 Your calculations are completely off and you missed something about the company’s situation or business model.
In order to show you real life examples, I’ve selected three interesting buys with wide margins of safety:
It’s a bad month for the market, and it also affected greatly BLK’s stock price. The concerns come from a general doubt around the industry of investment firms. Typically, this sector is making the bulk of their revenue from fees charged on the assets they manage (called assets under management – AUM). If the market drops, AUM will follow accordingly and fees charged will naturally decline. In addition to this situation, investors have the awful reflex to withdraw part of their money from the market when it drops. This pushes the AUM even lower. However, this recent drop in price is more likely to be a great entry point to buy this leader in the ETF industry. BLK’s leadership position as the largest investment firm combined with its ability to generate higher profitability than its peers makes it a great company to buy. The company is currently trading with a 20% margin of safety:
Among my three examples, CAT is probably the one that is closest to a falling knife and where the margin of safety could be a lure. I personally believe in the company’s leadership position in its sector. While the company could benefit from the solid construction industry in the US, this is about the only good news for the upcoming months.
Caterpillar announced another 10,000 layoff round after cutting 20,000 jobs back in 2009. The problem is that the mining industry is dropping like rock ;-). Nonetheless, now that the company is trading at a PE ratio under 11 and showing a dividend yield close to 5%, it could be a very interesting addition to your portfolio.
3M Co (MMM)
MMM is a great example of a good company with a falling stock price that is following the overall market without any good reason. The stock price has followed exactly the same foot steps as the S&P 500 since August.
However, the company shows a stellar balance sheet, awesome product and geographical diversification and a strong ability to increase its dividend payment in the upcoming year. If you pick it up now at a yield of nearly 3%, you will just make a steal off the market.
MMM has recently dropped to a 20% margin of safety. You can rarely pick shares of MMM at a 3% dividend yield.
How To Calculate your Margin of Safety
As you can see, I use a 15 cell discount model matrix. The Dividend Discount Model I use comes with a two stage dividend growth rate. A first one is used for the first 10 years and you have the option to change it for the years after. Then, the calculations are made for you automatically and generates 15 possible values for the same stock price analysis.
This helps you to put into perspective the effect of different discount rates and dividend growth rates used in your calculations. The spreadsheet is offered in my Dividend Toolkit package (you can read more about it here):