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Investing With a Margin of Safety

By Motley Fool Staff - Updated Apr 6, 2017 at 12:49PM

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Getting comfortable with the price you pay.

Knowing which stocks to buy is only part of the picture. Investors also need to know when to buy. Are shares a smart buy at $20 each? $75? $400? One of the things that should go into your calculation of when to buy is determining how much of a cushion you want against the chance that the stock won't reach your estimate of its actual market value.

Insisting on this "margin of safety" is one of the five keys to value investing for the team at Motley Fool Inside Value

The companies we recommend must have excellent management, great assets, strong cash flow, and a competitive advantage. Most importantly, the stock price must be trading at a significant discount to our calculation of intrinsic value. This discount will give us a margin of safety if events don't pan out according to our expectations.

What follows is a modified version of an article Inside Value advisor Philip Durell wrote for service members.

Benjamin Graham, the godfather of value investing and one of Warren Buffett's mentors, regarded margin of safety as the central concept of investing. Margin of safety is simply the percentage below your estimate of value at which you would be willing to buy a stock. Like Graham, we insist on a margin of safety, so we determine a buy-below price for each Motley Fool Inside Value recommendation for you to use as a guide.

The margin of safety is easy to apply if you have some concept of the value of the stock and the relative risk of owning that particular company. For example, we recommend buying Core recommendation Coca-Cola (NYSE: KO) at a smaller margin of safety than Chesapeake Energy (NYSE: CHK), because the uncertainty and risk of owning Coke is far less than of owning Chesapeake, whose value is highly correlated to short-term natural gas prices. On the other side of the coin, we think the potential rewards at Chesapeake are higher.

Every valuation that we calculate includes a range of potential values that we distill into a single intrinsic value, based on the probability that we assign to each scenario. The wider the range of potential outcomes, the wider we set the margin of safety.

Related Foolishness:

This material was originally published on the Motley Fool Inside Value website. An all-access pass to the service is available free for 30 days by clicking here.

Coke and Chesapeake are Inside Value recommendations. Coke is also a recommendation of Motley Fool Income Investor. Philip and The Motley Fool own shares of Chesapeake Energy.

This article was put together by Fool online editor Kris Eddy, who owns no shares of any stocks mentioned in this article. Try any of our investing newsletters free for 30 days. The Motley Fool's disclosure policy likes polka dots.

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Stocks Mentioned

The Coca-Cola Company Stock Quote
The Coca-Cola Company
$63.02 (-0.56%) $0.35
Chesapeake Energy Corporation Stock Quote
Chesapeake Energy Corporation

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