Valuation course · Lesson 10 of 10
A fair value is a range, so leave a margin of safety.
Each input in a DCF is an estimate, so the answer is a range. Scenarios show the range. A margin of safety protects you when the result falls at the low end.
Three cases
| Case | Growth in year 1 | Return on new capital | Weight | Value per share |
|---|---|---|---|---|
| Bull | 12% | 30% | 25% | $28.66 |
| Base | 8% | 24% | 50% | $23.92 |
| Bear | 3% | 9% | 25% | $15.27 |
In the bull case, growth starts higher and new capital earns more. In the bear case, growth starts at 3% and new capital earns only the hurdle. The weights are our judgment.
The weighted value is $22.94. It is below the base case, because the bear case is further from the base case than the bull case is.
The margin of safety
A margin of safety is a gap between the value and the price that you pay. With a margin of 25%, we would pay up to $17.94 a share. At $30, the price is above all three cases.
The margin pays for errors that you cannot see. It is larger for a company with a wide range of results, and smaller for a company with a narrow range.
What to do with the answer
- Write down the value, the range and the one assumption that matters most.
- Decide the price at which you would act before you look at the price again.
- Check the main assumption each quarter, and change the value when the facts change.
Our research reports follow these steps. Each call states a fair value and the cases around it, and we score every call against the index after twelve months.
Key points
- A fair value is a range, not a point.
- Weight the cases, and look at how far the bear case is from the base case.
- Pay a price with a margin of safety below the value.