

Margin of Safety

What it is:

Margin of safety is the amount by which a company's shares are trading below their intrinsic value.

How it works (Example):

The formula for margin of safety is:

Margin of Safety = 1 - Stock's Current Price / Stock's Intrinsic Value

Let's look at an example.

Assume an investor pays $9.50 for a stock he believes to be worth $10.00.

Because the investor is paying 95% of the estimated inherent value ($9.50 / $10.00), his margin of safety is 5%. If the same investor refused to buy the stock unless it was trading at $7.00 per share, he would have a much greater margin of safety of 30%.

Obv farther a company's shares have been pushed beneath their intrinsic value (sometime called "fair value"), the larger the margin of safety will be. Conversely, if a stock is trading at or even above its fair value, then the margin of safety on that type of an investment would be zero, making the shares theoretically subject to more risk.

Once the investor determines the intrinsic value of a stock and can therefore calculate its margin of safety, he must compare this margin to a benchmark rate of return on a low-risk investment. (In most cases, U.S. Treasuries are used as a benchmark for this risk-free rate of return.) By comparing the potential return of a stock or other investment to that of a risk-free bond, the investor can get a better sense for whether the margin of safety will adequately compensate him for the risk involved.

If risk-free rates (and thus, demand for fixed-income investments) are relatively high, investors might demand a larger margin of safety on their riskier stock investments. However, if risk-free rates are low, then investors might accept a lower margin of safety.

Why it Matters:

When the term "margin of safety" was introduced, it suggested that a stock's intrinsic value could be methodically calculated. Benjamin Graham, the conceiver of margin of safety, suggested this could be done by analyzing a company's assets and business model and forecasting its future earnings. Virtually all methods of calculating intrinsic value involve making predictions that may eventually prove to be inaccurate and/or could be influenced by unpredictable factors down the road. Decisions based on these methods therefore involve some degree of risk.

How large of a margin of safety is needed for a stock to be considered a true value investment? This depends on several factors, including market conditions, risk tolerance, and even the fundamental prospects for the company in question. When an investor feels very confident that his/her inherent value figure is accurate and unlikely to fluctuate substantially, then a thinner margin of safety might be suitable. This is usually the case with well-established firms in mature industries with clear earnings visibility and stable cash flow track records.  Trying to pin an exact fair value on other companies, particularly younger ones operating in volatile industries, can be an exceedingly difficult task. In this case, prudent investors should generally demand a higher margin of safety to compensate for the uncertainties behind the calculation.