It involves the estimation of a stock’s intrinsic or true value and comparing it to the current market price. By investing in stocks with a larger margin of safety, investors can be protected against unpredictable market changes, valuation errors, and unknown risks.
The principle of “margin of safety” was made popular by the British-American investor Benjamin Graham, who is recognized as the founder of value investing.
This principle is used by investors to assess a security’s true value by considering both qualitative and quantitative factors such as the quality of the firm’s management, governance, industry conditions, assets, and earnings.
The intrinsic value of the security is then compared to its market price to determine the margin of safety.
Warren Buffett, a famous follower of Graham’s principles, holds the margin of safety in high regard and considers it a fundamental aspect of his investing approach. He has been known to use a discount of up to 50% of a stock’s intrinsic value as his target price.
To calculate the margin of safety, the formula of preferred price to purchase a stock can be used:
Preferred price = Intrinsic value * (1 - Margin of safety).
The acceptable level of margin of safety varies depending on an individual’s risk tolerance and the stock’s risk grade.
For growth investors, a margin of safety of 15-25% is typically sufficient, while value investors may aim for a margin of safety of 40-50%.
Estimating the intrinsic value of a stock is not an exact science, and can be done through methods such as discounted cash flow analysis or using ratios such as price-to-earnings.
It is important to note that the margin of safety is only an estimate and requires practice to get right.
How to use margin of safety in equity investing
Explained by Raamdeo Agrawal
The “Margin of Safety” is a financial metric that calculates the amount of sales that exceeds the break-even point. This ratio provides insight into the actual profit of a company after all necessary expenses, including fixed and variable costs, have been accounted for.
the margin of safety allows investors to be more patient and strategic in their stock purchases, as they wait for the right price before investing in quality stocks.
This concept can also be applied to companies with an economic moat, potentially increasing long-term returns.