What it means
Graham taught at Columbia Business School and ran his own investment partnership, and his best known student was Warren Buffett. His writing moved investing away from tip following and towards the analysis of published accounts, asset values and long earnings records.
The approach was deliberately unglamorous and heavily evidence based. Two ideas carry his name into every investment committee.
The margin of safety is the gap between what a business is worth and what you pay for it, held as deliberate protection against being wrong. Mr Market is his image of the market as a moody business partner who quotes a different price every day, which you are entirely free to ignore.
His most mechanical method was the net current asset value test, often shortened to a net-net. It values a company on its current assets less all liabilities, ignoring goodwill, brands and any future growth, and looks for shares trading below two-thirds of that figure.
The idea is that you are buying liquid assets at a discount and getting the operating business for nothing. For a business audience the transferable part is the discipline rather than the arithmetic.
Graham insisted on writing down what a business is worth, and why, before looking at the asking price, which is the same habit that separates a disciplined acquisition from an auction won on enthusiasm. It also forces the uncomfortable question of what would have to be true for the price to be fair.
The nuance is that pure Graham bargains are rare in markets where value sits in people, software and brands rather than inventory and machinery. His successors kept the margin of safety and the respect for evidence while widening the definition of value to include durable earning power.
The method evolved; the insistence on a price below worth did not.
In practice
Real-world examples.
Example
A private investor screens a market for companies trading below their net current asset value and finds four candidates, three of which are loss making. She reads the accounts rather than the screen output, and rejects two whose inventory is slow moving and unlikely to convert at book value.
Example
An acquirer values a target on its own estimate of sustainable earnings, lands on $14,000,000, and refuses to bid above $10,000,000. The gap is the margin of safety, and the discipline costs the buyer the deal but avoids a later write-down.
Example
An investment committee rewrites its mandate to require a written valuation and a target buy price for every holding before any purchase. The practice is borrowed directly from Graham, and the committee finds it cuts impulsive decisions during volatile weeks.
Formula
Calculation
Net current asset value = current assets - total liabilities. Graham's test: buy only when the share price is below two-thirds of net current asset value per share.
A small engineering company reports current assets of $90 million and total liabilities of $50 million, so net current asset value is $90 million - $50 million = $40 million. With 10 million shares in issue, that is $40 million divided by 10 million = $4.00 a share, and two-thirds of $4.00 is $2.67. At a market price of $2.20 the share passes the test, and the margin of safety is $4.00 - $2.20 = $1.80 a share, which is $1.80 divided by $4.00 = 45% of the asset value.Case study
Seen in the real world.
Linden Partners is an illustrative, fictional family investment office used here to show the method applied with a straight face. In the illustrative story, the team studies a listed components maker with current assets of $90 million, total liabilities of $50 million and 10 million shares in issue, giving net current asset value of $4.00 a share while the market price is $2.20. Rather than buying on the screen result alone, the team checks whether the current assets are real: the receivables are collected within 45 days, the inventory is standard parts with an active resale market, and there are no large off balance sheet commitments. They buy at $2.20, and over the following two years the company sells a division and the share price reaches $3.90. The illustrative review afterwards is blunt about why it worked. The purchase price, not the forecast, created the return, and the margin of safety meant that a mediocre outcome would still have avoided a loss.
Watch out
Common mistakes.
- Treating a cheap price as a margin of safety by itself, without an independent estimate of what the business is worth.
- Applying the net current asset value test to asset-light businesses, where most of the value never appears in current assets.
- Taking balance sheet figures at face value, when ageing receivables and unsaleable inventory may not convert at book value.
Questions
People also ask.
Who was Graham's most famous student?
Warren Buffett, who studied under him at Columbia and later adapted the approach towards high quality businesses held for long periods.
What is the margin of safety in one sentence?
It is the discount between your estimate of value and the price you pay, sized so that being somewhat wrong still does not cost you money.
Is value investing only about low ratios?
No, the core idea is paying less than a business is worth, and a company on a high ratio can still be undervalued if its earning power is strong and durable.
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