Margin of Safety: Three Most Important Words

when it comes to investing! But what is it? What does it exactly mean? What we essentially hear is that it is buying $1.00 for $0.50, fair enough; but thinking about it over the last few days, I think there are two forms of margin of safety..

Form#1: This is the pure Graham version, where he determines that ABC Corp. is trading for $0.50 while the Book Value of the company is $1.00, the book value is solid. Mr. Market then recognizes that the Book Value is solid and sends the stock price up to reflect that fact. Now IF the company grew by 10% in that year the new Book Value would be $1.10, so we can buy this company for $0.50 and sell it for $1.10, remember most of the money has been made because of the value differential.

Form#2: And this is the modern form. When the US economy moved to a service based economy, there were fewer assets required to produce cash flow. Value investors could not really reply on Book Value's and with the times had to move on to Discounted Cash Flow (DCF) models. The intrinsic value of a business is the Present Value of its future cash flows (P/E and other relative valuation ratios are basically derived from a DCF). Now XYZ Corp.'s is growing at 20%, according to a DCF and has a fair value of $1.20 and the company is trading for $1.00. A value investor will only pay $0.60 for this company while a growth investor might pay around $1.00-1.20 (i really don't know what they would pay!). The value investor is banking that the valuation gap between the fair value (his) and the market will decrease and the growth investor is relying on future growth. This is all fine and dandy but will Benjamin Graham do it this way?

I think not! Remember in our DCF we are implicitly factoring in growth in the cash flows. And this comes down to how value investor's today value securities (and there is nothing wrong with this). We mortals like to label the different type of investing methods, some are value some are growth and so on n so forth. Warren Buffett has said that value and growth are joined at the hip, the only different in the price, and by price we mean margin of safety. Anyways, If we were to use Form#1 in modern day valuation what we would do is value this business factoring in a zero growth rate or a GDP plus (5%) growth rate and then demand a price which is 50% lower than what we figured. If the firm does grow 20% good for us, but we are not making money banking on the growth; we are making the money as the valuation gap seizes. Just something to ponder..