You wouldn’t buy a stock if you believed it was priced at more than it was worth. Instead, you would seek a margin of safety, which means the difference between a stock’s intrinsic, or actual, value and its current market price. The wider your margin of safety, the bigger your safety net in case things don’t work out as you expected.
In this article, we’ll review margin of safety and why it’s important to investors. We’ll discuss how to use the concept of margin of safety in your decisions as well as the pros and cons of doing so.
Definition and Examples of Margin of Safety
Margin of safety is the difference between a stock’s intrinsic value and its market price. The concept is a cornerstone of value investing, an investing philosophy that focuses on picking stocks that the market has significantly underpriced.
The larger your margin of safety, the more room you have to be wrong. If you believe a stock’s intrinsic value is $50, but you’re able to buy it for $30, your prediction can be off by 40% before you’d lose money. But if that same stock is priced at $48, you can only afford to be 4% wrong—which could happen due to errors in judgment, miscalculations, stock market volatility, and countless other unknown factors.
In accounting, margin of safety has a divergent meaning, but the concept is similar in that it leaves room to be wrong. Margin of safety in accounting is the difference between a company’s projected sales and its break-even point, which is the level of sales it needs to achieve not to lose money. Any sales above the break-even point are considered profit. When a company has a wide margin of safety, it can withstand greater revenue reductions before it starts losing money.
How Does Margin of Safety Work?
Benjamin Graham, the father of value investing and mentor of legendary investor Warren Buffett, pioneered the concept of margin of safety. In his 1949 book “The Intelligent Investor,” Graham wrote: “The margin of safety is always dependent on the price paid. It will be large at one price, small at some price, nonexistent at some still higher price.”
But investing with a wide margin of safety is more difficult than it sounds. Calculating a stock’s intrinsic value is subjective and complex. While investors use a variety of approaches, ultimately, they require predicting a company’s future cash flow and its level of risk.
Risks associated with the business itself aren’t the only types of risks investors need to account for. There’s also the risk that the overall stock market will drop, along with industry-specific risks, such as a shortage sparked by some unforeseen factor. There’s also the risk that you, as the investor, were wrong in your assessment of the stock’s intrinsic value. Margin of safety accounts for all of these possibilities.
Investors often look for companies with a low price-to-earnings ratio, or P/E ratio, compared with similar companies to identify undervalued stocks.
To account for these risks, value investors often seek to buy stocks that are discounted from their intrinsic value. For example, suppose Stock ABC trades for $90, but you’ve calculated its intrinsic value at $100. As you’ll see from the formulas below, that gives you a 10% margin of safety.
But that may not be sufficient, particularly for value investors or those with a low risk tolerance. Perhaps your required margin of safety is 25%. That means that either the stock’s price must fall to $75 or its intrinsic value would need to increase to $120 before you’d be willing to invest.
Margin of Safety Formula in Investing
The formula for calculating margin of safety for a stock is:
Margin of safety = 1 - [Current market price/intrinsic value] x 100
In the example above of the stock that’s valued at $50 but that’s priced at $30, this gives us:
40% margin of safety = 1 - [$30 current market price/$50 intrinsic value] x 100
Margin of Safety Formula in Accounting
The formula for calculating margin of safety in revenue terms for accounting is:
Margin of safety = 1 - [Budgeted sales - break-even sales]/Budgeted sales x 100
Let’s say a restaurant estimates its revenue will be $500,000 for the year, and break-even sales are $400,000. This formula gives us:
20% margin of safety = 1 - [$500,000 budgeted sales - $400,000 break-even sales]/$500,000 budgeted sales x 100
Pros and Cons of Margin of Safety
Creates room for error
Helps you account for multiple risks
Prevents you from going with the herd
Based on subjective factors
Doesn’t guarantee returns
Less appropriate for growth investors
- Creates room for error: Investing in stocks with a wide margin of safety gives you a safety cushion in case you’re wrong.
- Helps you account for multiple risks: To create a wide enough margin of safety, you have to account for multiple types of risks, including company-specific, stock market, and errors in your own judgment.
- Prevents you from going with the herd: Many investors end up overpaying for stocks because they invest according to the latest fad. Only investing when you see a wide margin of safety helps you avoid making decisions based on hype.
- Based on subjective factors: Margin of safety requires you to calculate the intrinsic value of the stock, which can vary widely by the approach and the individual investor.
- Doesn’t guarantee returns: Investing with a margin of safety is an important risk management technique, but it doesn’t eliminate risk. Even a wide margin of safety doesn’t guarantee you won’t lose money. Also, investing with too wide a margin of safety could reduce your returns.
- Less appropriate for growth investors: Having a large margin of safety is less important for growth investors, who are willing to accept greater risks for greater returns. Calculating the intrinsic value of companies in emerging industries can be challenging. But a growth investor is less concerned about spotting a bargain and more interested in maximizing returns.
What It Means for Individual Investors
The right margin of safety for you as an individual investor depends a lot on your risk tolerance and your investing style. If you’re concerned about minimizing risk, you might aim for a margin of safety of 20% or more. But if growth is your primary goal, a slimmer margin of safety may make sense.
Even if you don’t choose individual stocks, you can apply the margin of safety principle to your investment decisions by preparing for a variety of outcomes. Having an emergency fund is key so that you don’t have to cash out after a market crash due to an unexpected expense.
Dollar-cost averaging, or investing the same amount repeatedly at regular intervals, protects you from consistently paying too much for investments. You don’t need an exact margin of safety requirement, but it’s essential to give yourself room to be wrong.
- Margin of safety in investing is the difference between a stock’s intrinsic value and its current market price.
- Margin of safety in accounting is the difference between a company’s total expected sales and its break-even point.
- Investing with a wide margin of safety allows more room for error, but calculating margin of safety is challenging because a stock’s intrinsic value is subjective.