Deep-Value Investing, Fundamental Risks, and the Margin of Safety

Abstract

This article estimates the margin of safety for publicly traded companies. In addition to market price volatility, the model identifies three sources of fundamental risk: 1) risk that interim news may necessitate revision of an initial valuation estimate before profits can be taken; 2) uncertainty over the reliability of a value estimate; and 3) uncertainty over when market price will converge to the investor's value estimate. The model indicates that, while investors should demand margins of safety that are typically 10% to 25% of the share price, larger margins are justified for especially risky stocks.

Keywords: margin of safety, value investing, idiosyncratic volatility, convergence

JEL Classification: D52, D81, D82, G11, G12, G14