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Building in Room for Error

Related to the Upside-Downside Ratio

The margin of safety is one of Benjamin Graham and David Dodd’s most enduring contributions to the world of investing. The two coined the term in Security Analysis in 1934, and Graham expanded on the concept in The Intelligent Investor in 1949. The gist of it is that no matter how careful an analyst is, so many variables are involved in calculating a company’s intrinsic value and future sales and earnings that mistakes are inevitable. So buy a stock worth $12 at $10 instead of $11.50, because the wider the gap between the stock’s price and its intrinsic value, the bigger the margin of safety.

How much safety is warranted depends on the company’s quality. A speculative com-pany that’s losing money, carrying a lot of debt or operating in a shrinking industry reasonably demands a larger margin of safety than a profitable company that leads a growing industry and has a solid balance sheet. Graham and Dodd typically looked for a 50-percent margin of safety on speculative companies but would require a margin of only 10 percent for a high-quality issue.
All investors employ the margin of safety differently, since it’s tied both to intrinsic value analysis and an individual’s risk tolerance. BetterInvesting expresses the risk-reward tradeoff as the upside-downside ratio. The goal here is to evaluate the risk and reward potential of a stock over five years, assuming one boom and one recession. This analysis says nothing about the probability of a stock reaching any particular price. Instead, it expresses what a stock’s potential is. BetterInvesting recommends buying a stock only when the upside is at least three times that of the downside.
In calculating the ratio, you first find the extreme upside. For a company with growing earnings, estimate the stock’s highest price-earnings ratio over the next five years. This will represent “as good as it gets.” Then determine the company’s highest earnings per share over this period. Multiply them and that’s your extreme high.
Now do the same on the low end. Multiplying your estimated low P/E by the expected low earnings is a common way to do this. If the stock is already trading below your low forecast, you’ll want to revisit your assumptions.
Finally, take the forecast high and subtract the current price. Then divide that by the current price minus the forecast low. The result is the upside-downside ratio. Anything above 3:1 offers a reasonable margin of safety for growth stocks.
Some investors also like a margin of safety for selling stocks. The upside-downside ratio for existing holdings should be updated to see whether price appreciation has outpaced potential.
The analysts at Morningstar do something similar. They give a “fair value” estimate for every stock. For Wachovia, it’s currently $53. The stock recently traded at $34.60. Morningstar says to consider buying it at any price below $39.80, which is 75 percent of what Morningstar thinks the stock is worth.
If you buy the stock, Morningstar says not to consider selling it until it reaches $68.90. In other words, Morningstar believes Wachovia’s stock could increase by 30 percent beyond what it now considers the stock’s fair value. The answer to the selling conundrum in this case is that if Wachovia reaches its fair value, the investor has to analyze the stock again to see whether there’s room left for the stock to run.

BetterInvesting’s Online Tools

The Stock Selection Guide, the primary stock study tool of BetterInvesting members, helps you identify stocks that are reasonably priced. Our new online tool will walk you through evaluating a company using the SSG. Click on the Online Tools & Software link under the Tools & Resources menu on the BetterInvesting homepage. Your membership may already include access to the tool; if not, you can upgrade your membership to use it.

Michael Maiello, who wrote "Fly With The Fundamentals" for the January 2006 issue, is author of Buy the Rumor, Sellthe Fact (McGraw-Hill, 2004).

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