Last updated on 18 July, 2023
Our analysis takes a deep dive into evaluating the earning potential of a company, both as a standalone and in relation to other companies within the same industry as well as the broader S&P500 index. We conduct a thorough analysis of six specific measures that provide critical insight into a stock’s earning potential:
Metric E1: Margin of Safety based on Earnings (MOS_E) – This metric provides a perspective on the “safety net” beneath a company’s current market price based on its earnings. A larger margin of safety indicates a greater level of protection against uncertainties or downturns.
Metric E2: Price-to-Earnings Ratio (P/E Ratio) – This popular metric shows how much investors are willing to pay for each dollar of the company’s earnings. A higher P/E ratio can suggest the market has high expectations for a company’s future growth.
Metric E3: Price-to-Book Ratio (P/B Ratio) – This ratio is a comparison of a company’s market value to its book value. It gives an indication of whether a stock is under or overvalued, providing a snapshot of a company’s intrinsic value.
Metric E4: Earnings Per Share (EPS) Growth (TTM, QYoY) – This metric measures the percentage change in Earnings Per Share (EPS) over the trailing twelve months (TTM) and quarter-over-quarter (QYoY). It signifies how the company’s earnings are growing over time, showing its financial health and profitability trend.
Metric E5: Price-to-Earnings-to-Growth (PEG Ratio) – This ratio takes the P/E ratio and adjusts it for expected earnings growth. A lower PEG ratio can imply that a stock is undervalued given its earnings growth projections.
Metric E6: Enterprise Value-to-EBITDA (EV/EBITDA) – This multiple compares a company’s overall value (including debt and excluding cash) to its earnings before interest, taxes, depreciation, and amortization (EBITDA). It can be useful for comparing companies with different capital structures.
We discuss these six metrics regarding Earnings below, with examples. (The rest of this page is incomplete, as of 18 July, 2023)
Margin of Safety (MOS)
- Margin of safety is a concept in value investing that was popularized by Benjamin Graham, the father of value investing. It refers to the difference between the intrinsic value of a stock and its market price. In other words, the margin of safety is the discount that an investor requires in order to invest in a stock.
- The intrinsic value of a stock is its true worth, based on its fundamentals, such as earnings, assets, liabilities, and growth prospects. The market price, on the other hand, is the price at which the stock is currently trading in the market. If the intrinsic value of a stock is higher than its market price, it is considered undervalued, and vice versa.
- The margin of safety is important because it provides a cushion against potential losses. By buying a stock with a margin of safety, an investor is protecting themselves against the possibility that the intrinsic value of the stock may not be fully realized, due to unforeseen events or changes in the market.
- In practice, the margin of safety is calculated by determining the intrinsic value of the stock using various valuation methods, such as discounted cash flow analysis or price-to-earnings ratio analysis. The investor then sets a target price that is below the intrinsic value, typically by a certain percentage, to account for the margin of safety.
- For example, if the intrinsic value of a stock is $100, an investor might set a target price of $70, which represents a 30% discount. This discount provides a margin of safety that can help protect against potential losses if the stock does not perform as expected.
References:
Graham, B., & Dodd, D. (1934). Security Analysis. McGraw-Hill Education.
Klarman, S. A. (1991). Margin of safety: Risk-averse value investing strategies for the thoughtful investor. HarperCollins Publishers.
Graham, B. (1973). The Intelligent Investor: The Definitive Book on Value Investing. Collins Business Essentials.
Margin of Safety based on Earnings (MOSE)
Margin of safety can also be calculated based on a company’s earnings. This involves analyzing a company’s earnings history and projecting future earnings in order to determine the amount of buffer or cushion between the current price of the stock and its intrinsic value.
To calculate the margin of safety based on earnings, an investor may use the following formula:
Margin of Safety = (Current Earnings Per Share – Minimum Acceptable Earnings Per Share) / Current Earnings Per Share
The minimum acceptable earnings per share is the level of earnings that an investor is willing to accept based on their investment goals and risk tolerance. This can be determined by analyzing historical earnings growth rates, industry trends, and other relevant factors.
For example, let’s say a company has a current earnings per share of $3.00, and an investor’s minimum acceptable earnings per share is $2.50. The margin of safety based on earnings would be:
Margin of Safety = ($3.00 – $2.50) / $3.00 = 0.1667 or 16.67%
This means that the stock would have a margin of safety of 16.67% based on earnings, which provides a cushion against potential losses.
It’s important to note that while margin of safety based on earnings can be a useful tool for value investors, it should not be used in isolation. Other factors such as the company’s balance sheet, cash flow, and growth prospects should also be taken into consideration when evaluating a stock’s intrinsic value and potential for investment.
References:
Buffett, W., & Cunningham, L. A. (2009). The Essays of Warren Buffett: Lessons for Corporate America. The Cunningham Group.
Greenblatt, J. (2010). The Little Book That Beats the Market. John Wiley & Sons.
Mauboussin, M. J. (2012). The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing. Harvard Business Press.
These sources provide insights into different methods of calculating margin of safety, including the use of earnings-based metrics, as well as the importance of considering other factors when evaluating a stock’s intrinsic value.