Margin of safety in investing is a concept that was first propounded by Ben Graham, who is considered to be the father of modern investment theory. The concept has been applied at length by Warren Buffett and has been one of his key driving factors over the last many years of his successful investing career. Margin of safety, as the name suggests, refers to the comfort level or the cushion that the investor has in a stock when he buys the stock at a particular price. According to Buffett, most stocks would be worth buying if the price is right. Now let us understand the concept of margin of safety with reference to the intrinsic value of the stock.
Margin of safety with reference to the intrinsic value of the stock..
A stock's intrinsic value is a function of a variety of factors. There are financial factors like growth in sales, growth in profits, operating margins, P/E ratio, dividend yield etc. Then there are non-financial factors like the management quality, entry barriers created by the product, corporate governance standards, brands and other intangible assets of the company. The final valuation is arrived at by combining the impact of financial and non-financial factors. It is normally arrived at by discounting future cash flows and then adjusting it with the peer group P/E ratio and other qualitative factors. The output is the intrinsic value of the stock.
The intrinsic value is actually useful if looked at with reference to the market price of the stock. A stock is said to be underpriced if the market price is below the intrinsic value and it is considered to be overpriced if the market price is above the intrinsic value. But the big question is by how much is the stock overpriced or underpriced. This gap between the market price and the intrinsic value is referred to as the margin of safety. From an investor’s point of view, if the market price is substantially lower than the intrinsic value of the stock then the stock offers a high margin of safety and it is a good stock available for investment at an attractive level. On the other hand, from a seller’s perspective, if the market price is substantially higher than the intrinsic then it offers a higher margin of safety to sell or short the stock. Thus margin of safety works both ways, although it is popularly used to refer to a situation when stocks are deeply underpriced.
Why is margin of safety important?
The margin of safety is very important while evaluating stocks for the following reasons:
Most valuations are based on certain assumptions. While most of these assumptions are empirically tested, they could well go wrong. Hence a higher level of margin of safety will ensure that you are protected from such divergences in valuations.
We live in volatile times and there are many local and global risk factors that are beyond the control of investors and traders. Hence stock prices also tend to be volatile. Also, shifts in interest rates could change the economics of a stock and hence the intrinsic value. A higher margin of safety protects you against such vagaries.
As investors we all tend to make mistakes. They may pertain to our estimates of the company’s potential or the ideal level of entering a stock. A higher margin of safety will ensure that even if you do make mistakes, you are better protected due to a higher margin of safety.
It is a protection against the "Unknown – Unknown". There are some risks we are aware of and some risks we simply fail to recognize. Ben Graham referred to these risks as the "Unknown – Unknown". These risks can be best handled by the margin of safety concept. By buying stocks deeply below their intrinsic values, your stand a better of chance of beating the odds.
Margin of Safety and the Buffet "Bridge Analogy"..
A long time practitioner of the Margin of Safety Concept, Buffett compares this idea to building a bridge across a river. When you build a bridge you make it strong enough to bear the load of a 30-tonne truck. This is despite being aware of the fact that currently the maximum load will be 10 tonnes per truck. That is what margin of safety is all about. It keeps a cushion while investing since investing is always done with imperfect information and an incomplete understanding of the impacting factors. As Buffet himself says, it is impossible to get it all right when you are talking about the future. That is where the concept of margin of safety comes in handy. Essentially, a higher margin of safety makes your investment strategy as risk-proof as possible. After all, that is what smart investing is all about!