Explained: Role of Margin of Safety in terms of investing
The margin of safety (MOS) is referred to as one of the fundamental principles in value investing, where securities are bought only if their share price is trading below its approximated intrinsic value.
Benjamin Graham, the father of value investing and mentor of legendary investor Warren Buffett, pioneered the concept of margin of safety. In his book, ‘The Intelligent Investor’, first published in 1949, Graham wrote, “The margin of safety is always dependent on the price paid. It will be large at one price, small at some price, non-existent at some still higher price.
The margin of safety (MOS) is referred to as one of the fundamental principles in value investing, where securities are bought only if their share price is trading below its approximated intrinsic value. While investing, if a sufficient margin of safety exists, an investor’s downside risk is more protected.
Hence, the margin of safety acts as a ‘cushion’, permitting some degree of losses to be incurred except being hit by any major inference on returns. To rephrase it, purchasing assets at discount decreases the negative effects of any declines in value and also, reduces the chance of overpaying.
MOS formula
To elaborate, the margin of safety can be interpreted as the difference between the estimated intrinsic value and the current share price.
In order to estimate the margin of safety in percentage form, the following formula can be used:
Margin of Safety (MOS) = 1 − (Current share price / intrinsic value)
To quote an example, let’s say that a company’s shares are trading at Rs 10 but the estimated intrinsic value by an investor is Rs 8. Calculating the margin of safety, it comes to be 25 per cent. This can be interpreted as - there can be a 25 per cent drop in share price before it reaches the estimated intrinsic value of Rs 8.
MOS in value investing and risk
From a standpoint of assessing risk, the margin of safety can be considered as a safety cushion in the process of investment decision-making to protect investors from overpaying for an asset — i.e., if the share price indicates that it can decline substantially post-purchase. In comparison with using techniques like shorting stocks or buying put options as a hedge against a portfolio, margin of safety is viewed as a key approach in minimising investment risk by a huge proportion of investors.
This approach, bundled with a longer holding period, help investors better withstand any volatility in market pricing. On a general basis, the majority of value investors will not prefer investing in security unless the margin of safety is calculated to be around 20-30 per cent. If the margin of safety hurdle is 20 per cent, the investor will only purchase a security if the current share price is 20 per cent below the intrinsic value, based on their valuation.