Things to Know about the Business Investment
The company’s future income, but only to note the difference between earnings and fixed charges. If that margin was large enough, the investor would be protected from an unexpected decline in the company’s income.
If, for example, an analyst reviewed the operating history of a company and discovered that, on average, for the past five years the company was able to earn annually five times its fixed charges, then that company’s bonds possessed a margin of safety.
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The real test was Graham’s ability to adapt the concept for common stocks. He reasoned that if the spread between the price of a stock and the intrinsic value of a company was large enough, the margin-of-safety concept could be used to select stocks.
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For this strategy to work systematically, Graham admitted, investors needed a way to identify undervalued stocks. And that meant they needed a technique for determining a company’s intrinsic value. Graham’s definition of intrinsic value, as it appeared in Security Analysis, was “that value which is determined by the facts.”
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These facts included a company’s assets, its earnings and dividends, and any future definite prospects. Graham acknowledged that the single most important factor in determining a company’s value was its future earnings power, a calculation that is bound to be imprecise. Simply stated, a company’s intrinsic value could be found by estimating the earnings of the company and multiplying the earnings by an appropriate capitalization factor.
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The company’s stability of earnings, assets, dividend policy, and financial health influenced this capitalization factor, or multiplier. Graham asked us to accept that intrinsic value is an elusive concept. It is distinct from the market’s quotation price. Originally, intrinsic value was thought to be the same as a company’s book value, or the sum of its real assets minus obligations.
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