Margin of safety explained: How is it used in stock valuation?
The principle of margin of safety was popularised by a famed investor - Benjamin Graham and his followers, notably, Warren Buffett, who regarded it as the ‘cornerstone to investing’. Yet, outside the community of value investors, the concept of margin of safety is rarely used. Today, we will understand why it is important to incorporate this principle while investing.
Understanding margin of safety
In investing, the margin of safety is a principle in which, an investor only purchases securities when their market price is significantly below their intrinsic value. It is the difference in the market price of a security and the estimation of its intrinsic value. Investors may set a margin of safety in accordance with their own risk preference but buying securities when this difference is present, allows the investment to be made with minimal downside risk.
Let us understand this with the help of an example. Say, an investor was to determine that the value of ABC’s stock is Rs 1,000, which is well below its current market price of Rs 1,200. He might apply a discount of 20 per cent and target to purchase the stock at Rs 800. Even if he feels that the stock may be fairly valued at the current levels, he would absolutely limit his downside risk if he sets his purchase price at Rs 800. He might not be able to purchase the stock now but if the stock price declines to Rs 800 for a reason other than the collapse of ABC’s earning outlook, he could buy the stock with confidence.
Valuation and margin of safety
Given perfect company estimates and the rate of return desired, you can easily calculate the objective fair value of any business or asset that produces cash flow. However, we don’t have the perfect estimates, but only imperfect approximations. We can make estimates using historical growth rates, future trends that could shape growth rates and management projections with a range of models such as the discounted cash flow model (DCF) or the dividend discount model (DDM) but we are always going to have imperfect inputs.
For investors, the margin of safety serves as a cushion against errors in calculation. Since fair value is difficult to predict accurately, safety margins protect investors from poor decisions and downturns in the market.
How much of the margin of safety is sufficient?
The size of the margin of safety depends largely on investors’ preferences and the type of investing strategy that they use. This also depends largely on the risk appetite of the investor and the risk grade of the stock in question. For example, the margin of safety can be lower in large-cap stocks than in small-cap stocks. While a value investor would prefer a margin of safety of over 50 per cent, an aggressive risk profile investor would be okay with a 10-20 per cent margin of safety.
To sum up, it pays to be conservative and balance downside risks with expected returns, especially in the uncertain times we live in. By using the margin of safety concept, and by refusing to pay too much for an investment, you can minimise the chances that your wealth will ever disappear or suddenly be destroyed.