Yesterday, we discussed the meaning of “cheap” using an illustrative example. However, it’s very important to note that no simple example can fully mimic real-life scenarios. For instance, we purposely overlooked taxes and transaction costs. Further, the interest rate we assumed was 10%, which was chosen for ease of calculation but is considerably higher than the current rates you would receive at your local bank.
Nevertheless, the most crucial assumption that we made was that there was no uncertainty with respect to the return on the asset. In our example, the apple tree was guaranteed to produce 100 apples exactly one year from now, valued at $1 per apple (the prevailing market price), resulting in a total worth of $100. This allowed the buyer to have complete knowledge of what they would receive.
However, this certainty is rarely found in real-life situations. With fixed income instruments, there is certainty about the achievable return, such as a fixed interest rate of 5% on the amount lent. However, there is still a risk that the counterparty might default and not repay the principal and/or interest. Credit ratings and credit scores, applicable to corporate and individual lending, respectively, are meant to assist the lender in assessing this risk.
Stocks pose an even greater challenge. The value of stocks is not known with certainty; they can only be estimated. Although laws require the disclosure of information to ensure transparency between the promoter and the buyer, as a potential investor you still need to conduct an estimation of value exercise.
The concept of the margin of safety is precisely relevant in these situations.