What is 'Margin Of Safety'
Margin of safety is a principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with minimal downside risk.
BREAKING DOWN 'Margin Of Safety'The term was popularized by Benjamin Graham (known as the father of value investing) and his followers, most notably Warren Buffett. Margin of safety doesn't guarantee a successful investment, but it does provide room for error in an analyst's judgment. Determining a company's "true" worth (its intrinsic value) is highly subjective. Each investor has a different way of calculating intrinsic value, which may or may not be correct. In addition, it's notoriously difficult to predict a company's earnings. Margin of safety provides a cushion against errors in calculation.
The Thinking Behind the Margin of Safety
As scholarly as Graham was, his principle was based on simple truths. He knew that a stock priced at $1 today could just as likely be valued at 50 cents as it could be valued at $1.50 in the future. He also recognized that the current valuation of $1 could be off, which means he would be subjecting himself to unnecessary risk. He concluded that, if he could buy a stock at a discount to its intrinsic value, he would limit his losses substantially. Although there was no guarantee that the stock’s price would increase, the discount provided the margin of safety he needed to ensure that his losses would be minimal.
For example, if he were to determine that the intrinsic value of XYZ’s stock is $162, which is well below its share price of $192, he might apply a discount of 20% for a target purchase price of $130. In this example, he may feel XYZ has a fair value at $192 but wouldn’t consider buying it above its intrinsic value of $162. In order to absolutely limit his downside risk, he sets his purchase price at $130. Using this model, he might not be able to purchase XYZ stock anytime in the foreseeable future. However, if the stock price does decline to $130 for reasons other than a collapse of XYZ’s earnings outlook, he could buy it with confidence.
Buffett, who is a staunch believer in the margin of safety, has been known to apply as much as a 50% discount to the intrinsic value of a stock as his price target.