Margin of Safety is a term used to describe the difference between the current share price of a stock and its intrinsic value. In other words, it is the discount at which the stock is trading in comparison to its actual worth. The Margin of safety is not necessarily an equation but a guiding philosophy grounded in investment discipline. It invokes logical decision-making, fundamental analysis, a long-term mindset with a focus on risk management.

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The Margin of Safety explained.

The term “Margin of Safety” was made famous by Benjamin Graham, who was a pioneer in the field of Value Investing. Although the characteristics he looked for in companies trading below book value may have changed over time, the principle of Margin of Safety is still relevant today.

As we have learned earlier in Making Sense of Mr Market and Intrinsic Value Explained, the price of stocks keeps fluctuating over time. This volatility presents many opportunities for savvy investors who adopt the investment strategy of using a Margin of Safety.

The idea is to take advantage of the difference between the intrinsic value and the current share price of a stock. This allows them to buy stocks when they are undervalued or on sale, which means that they are trading below their actual worth.

The three most important words in investing…Margin of Safety.

Warren Buffett

When a company’s stock is trading at a significant discount to its intrinsic value, it provides an excellent buying opportunity for investors who require a Margin of Safety. The Margin of Safety is a theoretical concept, and no margin fits all strategies. Some investors require a higher discount and look for deep value (Buying a dollar for 50 cents) and other investors require a smaller margin perhaps 10%.

It will be set by the Investment strategy adopted by the investor as well as how risk-averse they are.

Why is a Margin of Safety important?

To better understand the Margin of Safety, let’s look at some real-life examples that illustrate how we may already be using the concept. Imagine you have an important job interview. To avoid being late due to unforeseen circumstances, you arrive an hour early. This hour is your Margin of Safety should unfortunate events happen, like a traffic jam.

Similarly, when going on a hike, I usually carry 2 litres of water. However, on a recent hike, I decided to take an extra bottle, providing me with a total of 4 litres of water. The additional 2 litres was not needed but it served as my Margin of Safety in case I got stranded.

A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.

Seth Klarman

The Margin of Safety concept provides a safety net or buffer in case things don’t go as planned. Stocks can be volatile, and we may make incorrect assessments or valuations. Having a Margin of Safety not only increases the chance of making a profit but also protects against potential losses.

When determining the intrinsic value of a stock, the process is subjective and based on unknown assumptions. While we can improve our valuation process and verify our assumptions, it is still a hypothetical outcome. The Margin of Safety acts as a contingency plan in case our models and forecasting are incorrect.

All investment styles can benefit.

The Margin of Safety is a concept that is often associated with Value Investing, but it can be beneficial for all types of investing. It is important to note that the market offers opportunities every year to purchase excellent stocks at a discount. By applying this strategy, we can take advantage of price disparities that exist between a company’s 52-week high and 52-week low ranges.

Even if you prefer companies that focus on growth and quality, these types of companies are often presented at a discount. Who wouldn’t like to buy a quality growth company with a 10% or 20% discount?

As a growth investor who primarily scans the smaller-cap markets, I still adopt the Margin of Safety idea. While it does not shape my overall investing decisions, it certainly strengthens my buying opportunities when they are presented to me.

The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.

Benjamin Graham

Sometimes, I believe that some growth companies have too much hype built into the price. Although I have purchased at 52-week highs and carried that momentum higher, I still do not like to pay more than what I think something is worth. So, I wait. Sometimes, a buying opportunity presents itself, and sometimes it does not. It’s not a perfect game.

However, we cannot cry over spilt milk. You cannot win them all. Having a strict valuation and investment discipline grounded in a Margin of Safety means that you will miss many investments. The outcome, however, is that you load up on ideas with a margin according to your philosophy, which can maximise profits while reducing your risk.

What is the Margin of Safety formula?

The Margin of Safety formula is quite simple once you have determined the Intrinsic Value.

Once you have determined this it is a matter of comparing your Perceived Price per share to the current market price. This will then show you how much safety is built in or perhaps indicate there is no safety at all.

Margin of Safety = (Intrinsic Value – Market Price) ÷ Intrinsic Value x 100%

As a quick example, let’s assume that a company is trading at $55.50 per share. We conduct an in-depth analysis of the business using one of the various valuation methods and conclude that we believe the Intrinsic Value is $61.33 per share based on our DCF. The formula would look like this.

($61.33 – $55.50) ÷ $61.33 x 100%

Margin of Safety = 9.47%

This formula is a great way to look at the value of assets against what you believe the value to be. Your Investment criteria will shape what type of margin you expect. For example, if you demand that stocks must have a 20% Margin to be investable then anything below this is not considered.

How to use the Margin of Safety?

It’s important to determine the margin of safety when developing your Investment Strategy. Knowing this in advance will help you to identify the discount you need while looking for undervalued investment opportunities.

Let’s say you’re a value investor who follows a 25% margin of safety on all buy-side decisions. This investment criterion is part of your overall investment strategy. We’ll use this 25% MOS as our basis for the following example.

Suppose we’re evaluating three companies in an industry that we believe has a future, but is currently going through a downturn. We want to take advantage of this opportunity but also need a margin to protect ourselves from potential losses.

	Company A	Company B	Company C
Current Share Price	$12.80	$21.70	$9.80
Intrinsic Value	$19.73	$24.50	$7.65
Margin of Safety %	35.12%	11.42%	– (28.10%)

Company A

($19.73 – $12.80) ÷ $19.73 x 100% = 35.12% Margin of Safety

UNDERVALUED within out Margin requirement.

Company B

($24.50 – $21.70) ÷ $24.50 x 100% = 11.42% Margin of Safety

UNDERVALUED but not investable due to our 25% Margin demand.

Company C

($7.65 – $9.80) ÷ $7.65 x 100% = -28.10% NO Margin of Safety

OVERVALUED as the price exceeds our Intrinsic Value Calculation.

In this example, we have evaluated three companies based on our criteria. Company A meets our standards and offers a sufficient safety net to protect us from potential losses. Company B is undervalued but does not provide enough of a buffer for us. On the other hand, Company C is overvalued as our intrinsic value estimate is higher than its current share price.

Whilst this is a highly simplified example it shows how a margin can be implemented and the Philosophy behind it.

Can a Margin be applied to Growth?

Valuing a growth business can be complicated. This is because sometimes hyper-growth businesses or smaller companies don’t have the free cash flow or profitability yet to forecast and determine intrinsic value. This makes it hard to put a margin of safety on a business. Even multiple valuations can be challenging, especially when some hyper-growth companies have price-to-earnings in the hundreds.

Instead, I try to adopt an approach using valuation tools that are best suited to valuing these types of businesses. The key is to reverse engineer the growth expectations.

The key is to ask “What growth has been built in?” and “What is the likelihood of this growth playing out?”. Once we’ve determined what growth has been built we can see whether a margin of safety exists. This is not an exact practice, but I have found it helpful in the past.

We can reverse engineer the growth expectations and evaluate the total addressable market, look at the landscape, the market penetration, and then roughly model out some earnings based on estimating revenue growth.

For example, if we are evaluating an emerging small-cap in hyper-growth mode we can look at the growth expectations based on the multiples. If we look at what’s been built-in, for example, the market expects this company to grow at 25% annually for the next 3-5 years while it captures market share, we can evaluate the possibility of this.

If I believe that the earnings growth and sales can expand at 40% a year for a few years, then there is a margin of safety between the market expectation and my own assumptions.

In Summary…

It is important to note that the margin of safety is theoretical and may not always be practical. This is because it is based on the intrinsic value calculations and valuations of a company, which may not be accurate in the real world.

It is also important to understand that excellent companies don’t often go on sale, which means that they may not provide a margin of safety. Some investors calculate the margin of safety between the intrinsic value and current share price, while others add an additional margin on top of the intrinsic value price.

For instance, if an investor wants a 20% safety buffer and a company is currently trading at $100 a share, and you calculate the intrinsic value to be $90 per share, the margin of safety should be calculated on the intrinsic value price, not the discrepancy between the current share price and the true value.

In this case, the margin of safety would be $90 minus a further 20%, which would equal $72 per share. This price is the target price that the investor should patiently wait for the stock to reach. By doing so, the investor achieves a 20% margin of safety on their intrinsic value estimate.

Using a Margin of Safety in your Investment Philosophy requires patience. You profit when the market recognises the discrepancy between the value of the underlying business and the trading price. This discovery could take years.

Using this technique is a great way to mitigate risk. The market is volatile and protecting the downside with a buffer can help to limit permanent capital loss should your valuation be out.