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Course 110
Buying at a Discount to Fair Value


Even though you now know about economic moats (see Stocks 109) and have perhaps uncovered a company that has at least one good-sized moat, unfortunately, your work is only half done at this point. You can't just go out and pay whatever the market is asking for this stock until you calculate what it's worth. Otherwise, you might end up having to hold the stock for many, many years to get a decent return on your money. And in some cases, you might never get one.

Price Matters

As in real life, price matters in the stock market. Just like you wouldn't run out and pay $10 a gallon for gasoline, why would you pay 100 times earnings for a company that is growing 15% a year? Do you think the people who paid $212 for Yahoo YHOO in January 2000 are ever going to get their money back? Yahoo's a good company, but it may take a very long time for the stock to get back to its old highs. The same could be said of Cisco Systems CSCO, EMC EMC, Oracle ORCL and any number of other technology companies with moats around them that got clobbered in recent years.

Remember--the single greatest determinant of a company's return in your portfolio is the price you pay for its shares. As important as it is to understand the quality of a company--its growth prospects, competitive position, and so forth--it's even more vital that you pay a fair price for that firm's shares. You'll make a lot more money buying decent firms with low valuations than by paying premium prices for premium companies. Why? Because the future is uncertain, and low valuations leave a lot more room for error.

Waiting for the Fat Pitch

So the question is: How do I make sure I don't overpay for something? The answer: If the pitcher doesn't throw one right down the middle, you don't have to swing the bat. Unlike in baseball, there is no penalty for being patient in investing. With the market pitching, you can let as many knuckleballs and sliders go by as you want and only swing at the slow pitches that come right down the middle.

What this means is that you should spend a fair amount of time placing a value on a stock before you even think about buying it, and only buy stocks that you are confident are undervalued.

Learning how to value a stock takes work, but it can be done. For those who want to learn how to do this themselves, our entire Stocks 300 track deals with this topic. For others who want to leave some of the heavy lifting to someone else, Morningstar's stock analysts also publish their estimates of fair value for roughly 500 stocks.

Margin of Safety

Even after you think you have a good handle on what a stock should be worth, it is important to buy at a discount to this estimated fair value to give an adequate margin of safety. After all, no projection about the future is foolproof, and protecting yourself from unforeseen events is entirely prudent. For instance, if a company's new product falls flat and profit growth doesn't materialize, you want to be protected.

It's also important to realize that some companies are riskier and harder to predict than others. In general, the riskier a company is, the larger the margin of safety should be.

The bottom line is that if you don't use a lot of discipline and conservatism in figuring out the prices you are willing to pay for stocks, you will regret it eventually. You might be able to sell some of your overvalued shares to some sucker who is willing to pay an even more inflated price, but in the end, this kind of speculating is the investing equivalent of musical chairs, with the last one holding the stock the loser. Don't let it be you. Buy at a price below fair value with an adequate margin of safety and sleep well at night.   

Quiz 110
There is only one correct answer to each question.

1 "Finding Economic Moats" and "Buying at a Discount to Fair Value" are what?
a. Two of Morningstar's Four Principles of Profitable Investing
b. Useful in speculative day-trading.
c. Both the above.
2 What is the single greatest determinant of a company's return in your portfolio?
a. The size of the company's economic moat.
b. The quality of the company's management.
c. The price you pay.
3 Why is a Margin of Safety important?
a. To account for possible errors in projections about the future.
b. To keep a conservative stance with your investments and sleep better at night.
c. Both of the above.
4 Morningstar found that many great investors…
a. Pay no attention to price and only look for "what's hot."
b. Buy at a discount to their estimates of fair value.
c. Spend a lot of time looking at stock charts.
5 Investors looking at riskier and harder-to-predict companies…
a. Should demand a larger margin of safety.
b. Can be happy with a smaller margin of safety.
c. Should just pay the current market price.
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