Margin of Safety

Well, it is a good idea to focus on "margin of safety" because it forces you to pay attention to the valuation of the stock when you buy it. Essentially, the process requires you to look at the fundamentals of the company and give it a value. There are different ways of valuing a company. One method is the 'Sum of the Parts' Method (SOTP) in which we ascribe a value to the different assets. The other is the 'replacement' method where we ascertain what it would cost to buy another asset of the same capacity at today's prices. Yet another method is the 'yield' method in which we look at the past and future earnings of the company and seek to capitalize it at a certain value.

Another aspect of 'margin of safety' is the dividend yield that a stock offers. Generally, a company with a regular dividend payout and a healthy yield will resist downward pressures to the stock price.

The difficulty with determining the proper valuation of a company is that it is highly subjective and values can differ from person to person depending on what the focus areas are.

However, the biggest advantage of focusing on such aspects is that it will give you a better understanding of the company and help to develop your conviction about its prospects.

 

Well, several brokerages use SOTP as a valuation method to arrive at the fair price of the stock. For instance, IndiaNivesh has valued Ashiana Housing, a real estate company, on the SOTP method at Rs. 290. Assuming this valuation is correct, the current price of Rs. 211 offers margin of safety that you are not buying an overvalued asset. Similarly, they say that Tata Motors' SOTP valuation is Rs. 496. So, the current price of Rs. 393 has some margin of safety.

In contrast, ICICI-Direct has valued Wim Plast at Rs. 1620. This means that the current price of Rs. 1982 has no margin of safety.

Among the high dividend yield stocks, there are names like National Aluminum which has a dividend yield of 4.74%, RSWM with a dividend yield of 3.68%, IndiaBulls Housing with about 3.23%, GIC Housing with about 3% etc.