Central to the art of value investing is the concept of intrinsic value. It's a number that represents an investor's understanding of the true worth of a company under consideration.

After determining that magical number, value investors will purchase shares only if the market price for the company is significantly below that intrinsic value. That discount off the company's fair price is called the margin of safety. And the larger that margin at the time of purchase, the better the odds of superior risk-adjusted returns for investors.

There are two key reasons why the margin of safety gives investors a better-than-decent shot of coming out ahead. By taking advantage of both, Motley Fool Inside Value advisor Philip Durell has put together a series of recommendations that together have trounced the S&P 500 during the short life of the service. Of course, the race is just beginning, and there are no guarantees in the stock market. But there is significant historical data to suggest that Philip's strategies just might keep their lead.

The first reason is that the margin of safety provides a measure of downward protection against corporate stumbles. Unless you have a crystal ball that works better than mine does, you will invest in at least one company that fails to perform to your expectations.

Crash protection
Shortly after Philip recommended pharmacy services company Omnicare (NYSE:OCR) to Inside Value subscribers, changes were announced to the way many state Medicaid programs reimburse for Omnicare's services. Those changes have in fact hampered the company's bottom line, but its stock has still outperformed the S&P 500 index since his recommendation. This apparent contradiction is due to the margin of safety. At the time of his recommendation, the stock had been under significant pressure because of rumors about the governmental reimbursement rates and difficulties in its attempt to purchase its rival, NeighborCare (NASDAQ:NCRX). Yet since the company's stock had priced in far worse news than what had actually been delivered, the earnings release was met with a significant relief rally.

Likewise, when I first uncovered homebuilder Lennar (NYSE:LEN) in August 2004, it closed significantly below my fair value estimate. Since then, the company announced that it would be delaying delivery of some 600 homes, a significant chunk of revenue for the firm. In spite of that bad news, the business continues to operate well overall, and its shares have rewarded investors. Once again, the margin of safety provided investors a benefit, as the bad news predictions reflected in the stock price ended up worse than the actual bad news.

And on the upside.
As well as providing downside protections, there's another benefit to the margin of safety: the opportunity for potential market-beating returns on the upside. Remember that the margin of safety represents a discount to the price where an investor believes a company should be trading based on its fundamental financial data and prospects. Companies often trade at discounts to their intrinsic values when bad news abounds, such as lowered expectation for future growth, missed earnings numbers, large-scale lawsuits, and other legitimate business issues.

If and when the bad news subsides or is replaced by positive information, the pricing pressure usually lifts, and the company's stock price can rebound -- returning to a number closer to the firm's intrinsic value.

For example, consider one of Philip's Inside Value watch list companies, Cardinal Health (NYSE:CAH). When first presented as a potential value candidate, the company's CFO had resigned amidst an accounting scandal that triggered an SEC inquiry. The stock had dipped to around $43.70, its lowest price since 2001. Yet as time progressed and the company grew more adept at operating under the restructured business model it designed in response to the investigation, its stock has regained some of its former luster. At a recent price of $58.55, it's still below pre-scandal prices, but investors with the confidence and patience to hold through the controversy have been rewarded with a nice recovery.

These benefits from value investing can be achieved only if the companies being researched and purchased are truly values, rather than value traps (companies that appear cheap on the surface but whose businesses are weaker than initial investigations reveal). Sometimes, it's difficult to tell the difference. For example, when Bank of America (NYSE:BAC) announced its intent to purchase FleetBoston, fellow Fool Bill Mannscorned the high offering price, suggesting that the company's stock should have fallen even further than it did. I took his warning that Bank of America might be a value trap very seriously. In the end, though, I've been rewarded by my decision to hold the value-priced shares I had purchased on the merger-induced weakness.

Legendary investor Benjamin Graham likened value investing to playing roulette, albeit with the casino's odds rather than the gambler's. There is no assurance of success with any given investment, but with the margin of safety in the investor's favor, the probability of overall success increases across a well-diversified portfolio of value-priced companies.

Turning the table
To assure that the odds remain in the value investor's favor, that investor must be conservative in estimating intrinsic values. Any valuation methodology can be influenced by the investor's own biases, and it's far too easy to be overly aggressive in forecasting the future (see my recent article Controlling the Carnage for some bloody examples). No matter what technique is used to determine a company's intrinsic value, it will help the investor find potential superior returns only if that model presents a value that is realistic, or even a bit pessimistic. For my personal portfolio, I primarily use a combination of the dividend discount and discounted cash flow models, although I have been known to dabble in potential book value bargains.

With Inside Value, Philip has done a fantastic job of determining intrinsic values and coming up with sufficient margins of safety to protect subscribers. As of this writing, his selections as a whole have trounced the S&P 500, and only two of his 14 picks trail the index since selection. The worst performer to date, government-sponsored mortgage financier Fannie Mae (NYSE:FNM), is down due both to an accounting scandal of its own and to political concerns that it and its brother company Freddie Mac (NYSE:FRE) may face tighter congressional scrutiny and controls in the future. Even with the U.S. Congress breathing down its neck, Fannie Mae has retained better than 82% of its value from the day Philip selected it. Not a bad track record, though it does show that not even Philip can time the exact bottom of a company's stock.

By using conservative intrinsic value estimates to determine what a company is worth, investors can place a number where they rationally believe that firm should be trading. By buying only at prices below that value, investors set themselves up to be the casino running Benjamin Graham's roulette wheel, rather than the gambler wildly speculating on a wing and a prayer.

Like the idea of having the casino's odds, rather than the gambler's? A free trial to Motley Fool Inside Value is just a click away.

Fool contributor and Inside Value team member Chuck Saletta owns shares of Omnicare, Bank of America, and Lennar Class B. The Motley Fool has a disclosure policy.