IFB21: The Benjamin Graham Formula for Finding a Margin of Safety

Welcome to session 21 of the Investing for Beginners podcast. In today’s session, we are continuing our discussion of the Intelligent Investor and working through chapter 20. Again, this is one of the chapters highlighted by Warren Buffett as one of the most influential for him.
This is the chapter that opened my eyes with the discussion of the margin of safety. As a conservative guy by nature, this strategy struck home with me. There is much more to the chapter than this simple idea, check out our show notes to learn more.

* Margin of Safety equals earnings yield minus bond yield
* Amount of margin of safety depends on the market pricing
* Using data over a period is critical
* “Heads I Win, Tails I don’t lose that much.”
* Roulette as an example of diversification
* 2/3 or less of value is an adequate margin of safety
* No good stocks, just bad prices.
* Arithmetic is greater than optimism
* “Have the courage of your knowledge and experience…..THEN ACT on it!”

Dave: These two chapters are Warren Buffett’s favorite of the Intelligent Investor, and they are chock full of all kinds of wisdom and great advice to help you invest better.
The first thing that he talks about is the margin of safety in this chapter, and Andrew I am going to let you chat about this for a second.
Andrew: So obviously Dave and I we love to talk about margin of safety, with an emphasis on safety. Benjamin Graham started that whole movement, which has been passed on through the generations. With many great investors put a big focus on margin of safety.
Everybody has their definition of what a margin of safety means to them; I know they certainly do. It can be valuation based, balance sheet based, and how Benjamin Graham defined it. I am surprised because I don’t hear it that much when other investors talk about it.
In the very beginning of the chapter, he talked about how he could find it as the earnings yield minus the bond rate. You think about the bond rate, and he’s talking about the interest rate that a bond will pay for that company. And the earnings yield is just the inverse of the price to earnings ratio.
With the price to earnings ratio, we like to see a lower price to earnings is better. Since the earnings yield is the same ratio just flipped, a higher earnings yield is better, and the higher the earnings yield, the more profitable you are.
How the applies to investors, theoretically and in practice. What essentially happens is represents the earnings of a company, and once the company receives its earnings it will pay it out in dividends, or they reinvest it into the company.
The two components of the earnings yield, if you take that earnings yield and subtract the bond rate you are left with this cushion that the company has of earnings. They either are going to use for dividends or reinvest in the company.
The higher that earnings yield is above the bond rate, the greater the margin of safety.
Because a bond is something that can be purchased through the market, it is that guarantee that the company is going to pay based on what their balance sheet is. You can think of it as a margin of safety, as a cushion because they have that many earnings over that kind of base rate.
If those earnings drop or things go wrong with the busine...