Margin of Safety Example:

Margin of Safety Example: 
Here’s an example of how an undervalued stock selection can offer outsized returns.

Suppose you use the Toolkit Spreadsheet or some other Dividend Discount Model tool to determine the fair price of a stock. Let’s use the above example, where it was calculated that a company paying $1.80 in dividends per share this year and growing that dividend by an average of 5% per year into the future, with a discount rate of 12%, is worth $27/share.

What this means is that if the company performs as expected, then buying at $27 should give you long-term returns of around 12% per year. Now, in any given year, the stock may go up or go down; it could fluctuate wildly around that fair value. And of course you’ve got to occasionally adjust your fair value assessment to take into account new information (like how this site re-analyzes the companies I cover on an annual basis). But over the long run, earnings determines price.

For example, let’s say that the stock that pays $1.80 in dividends per share (DPS) this year has $2.50 in earnings per share (EPS) this year. If you pay $27/share for the stock, then you’re paying a price-to-earnings ratio (P/E) of 10.8, and the stock has a dividend yield of 6.67%.

Ten years from now, if it grew earnings and the dividend by 5% per year as expected, then their dividends per share are now $2.93 and the EPS is up to $4.07. This is their fundamental performance, but let’s see two different buying scenarios.

Scenario A: Buy at Fair Value
In this scenario, the investor buys 100 shares at $27, for a total investment of $2,700 and a total dividend income stream of $180/year. If the company grows EPS and the dividend by 5% per year for the next ten years as expected, and if the investor reinvests her dividends each year, then by the end of the 10 year period if the stock remains at fair value for this whole time, she’ll have over 190 shares at a price of nearly $44 each, and so her total investment will be worth $8,385 and her annual dividend income will be $559.

Now, that’s an increase in wealth from $2,700 to $8,385 over a 10 year period, which translates into a 12% annualized rate of return. (The rate of return matched the discount rate that was used to calculate fair value in the first place.) Dividend income rose from $180 to $559, which is also a 12% growth rate (which includes the natural dividend growth and the accumulation of more shares due to dividend reinvestment.)

Scenario B: Buy at 15% Discount to Fair Value
In this scenario, the fundamentals of the stock are identical. The initial EPS and DPS, and their growth rates through the 10 year period are identical to scenario A.

But this time, the market is depressed, and the investor buys shares at a 15% discount to her calculated fair value of $27, which means she buys the shares at $22.95. She can buy 100 shares for $2,295, and will have the same $180 annual dividend stream to reinvest.

Over this ten year period, let’s say the price of the stock gradually increases back up to fair value as the market sees this company continue to perform well. So in the starting period, it’s at a 15% discount, then later only 10%, 5%, and eventually is at fair value. So the price increases from $22.95 to $44. Because shares were cheaper on average over this period but her dividends were the same, she was able to accumulate more shares. By the end, she has around 200 shares at nearly $44 each, for total wealth of $8,768. Her annual dividend income is $584.

So, her investment increased from $2,295 to $8,768 over 10 years, which translates into a 14.3% annualized rate of return. (If she had bought $2,700 worth of shares initially, she could have bought more than 100, and she’d be up to $9,650 or so in wealth.) Her dividend income stream increased from $180 to $584, which is a 12.5% annualized rate of return, and it took significantly less capital to acquire the same income stream (she could have used the initial $2,700 to buy more.)

Same company, same performance, and yet buying at a 15% discount to fair value meant 14.3% annualized returns instead of 12% annualized returns. This means more money in the end, and larger income streams.

Conclusion

As a recap, the purpose of buying with a margin of safety is twofold:

1) It makes your portfolio more conservative because your growth estimates could be a little bit off and the investment will still work out.

2) If your estimates are correct, then your rate of return will be superior over time because the growth rate of the investment is augmented by the additional fact that you bought it at an undervalued price. Over the longest term, your results will be superior either because the market eventually returns the price to its fair value, or because for as long as its under its fair value, your reinvested dividends or the company’s share repurchases will be able to buy more shares for the same amount of money.

To calculate intrinsic fair value, the fundamental way is to use a version of Discounted Cash Flow Analysis, either on the company as a whole or on a share of a dividend paying company. When it’s done in the second way it’s called the Dividend Discount Model. The inputs you’ll need are the current free cash flow or dividend, the estimated growth of that free cash flow or dividend, and a discount rate, which is equal to your target rate of return for practical purposes. When DCFA is understood, then there are shortcuts that allow for reasonable valuation such as basing estimates on P/E, the PEG ratio, or shareholder yield, etc.

This article was written by Dividend Monk. If you enjoyed this article, please subscribe to my feed [RSS]