The margin of safety of an investment is vitally important when it comes to value investing. Value investors are usually aware of the margin of safety on their investment. The margin of safety of a stock essentially acts as a cushion for any vague assumptions and may ensure you reduced downside in the case when your assessment doesn’t prove to be completely right.
Margin of safety can be viewed as an additional buffer and tool that will reduce the downside risk of your investments. If your assumptions about the future turn out to be correct in the long run, your ultimate return might even be significantly higher than expected due to the margin of safety. On the other side, if those assumptions appear to be not fully right, the margin of safety may account at least to a certain extent for the resulting outcomes.
What Is the Margin of Safety?
By definition, the margin of safety is the spread between the intrinsic value of a stock and its current market price.
The higher the difference in intrinsic value and market price, the more space your investment can have for unexpected activities. This essentially concludes that the bigger the margin of safety, the lower your downside risk.
To define the margin of safety of a stock, you first need to find out the intrinsic value. The intrinsic value or also called fair value is the ‘true value’ of a stock that you define for yourself. It differs from each investor, as there are several factors that influence the fair value assessment such as growth estimation or the required rate of return. As a result, even when analyzing the same company, the margin of safety is going to be different for everyone, as the intrinsic value always varies in line with the investor’s view.
In other words, margin of safety will change in accordance with the intrinsic value. Therefore, there isn’t necessarily only one true margin of safety of an investment. Instead, it depends on the fair value of the investor and the current market price.
Any stock that is priced at a value which is below its intrinsic value, is considered undervalued. The more undervalued a stock becomes, the greater the margin of safety.
While the chart above isn’t meant in any way to accurately project the price and fair value movement of a stock, in reality, you may have also noticed that the chart of the stock price is much more volatile and than the progression of intrinsic value. It is essentially those price fluctuations of the market that allows value investors to invest in stocks at a discount and with a margin of safety.
That being said, you should also note that a margin of safety doesn’t necessarily guarantee a profitable investment, simply because it completely depends on your personal intrinsic value as mentioned above, and due to the fact that the market can’t be predicted. However, what the margin of safety can do is, as its name suggests, provide you with an additional amount of safety.
Example of Margin of Safety
Let’s assume that there is a company ABC, with its stock currently trading at a market price of $120. As value investors, we could now calculate the intrinsic value of the stock to see if it would be out the reach of the current price.
That being said, an undervalued fair price of a stock is certainly not the only requirement for a great investment. Before performing any intrinsic value calculation, the analyzed company should also have several other positive fundamental characteristics such as a growing bottom line, low debt and great long term prospects. Assuming that all required criteria of your individual company standards are met, you could arrive at your intrinsic value of the stock by performing a Discounted Cash Flow Analysis (DCF).
The discounted cash flow analysis can be used for any asset that provides a constant stream of cash flows. In this part of the analysis, we estimate the fair value of a business as the sum of all future cash flows that we are going to receive as a shareholder from the company. The number of future cash flows is furthermore discounted to the present with a required rate of return. The intrinsic value thus depends on how much cash flow we expect a company to produce and how much of a return we want to achieve.
In other words, if we expect at least a 15% return of an investment, our fair value is going to be substantially lower than if we would only require a 5% return. The same can be said for the growth aspect of the business. A fast-growing company will need to be considered at a high fair value, as opposed to a company with relatively slow and moderate growth.
Now let’s suppose that we have determined the intrinsic value of company ABC to be at $160. This would clearly indicate that the stock is undervalued. As mentioned above, the margin of safety is the difference between intrinsic value and the current market price. In this case, the margin of safety would be $160 – $120= $40. Therefore, we would conclude that the company ABC is trading at a discount of 25% of its ‘true value’.
How to Use the Margin of Safety
One question that might be asked is how much margin of safety would be appropriate for an investment. The simple answer would probably be that the greater the margin of safety the better for you as an investor, as it would essentially limit your losses or enhance your potential returns.
However, one of the flaws of the margin of safety may be the fact that chances for you to find suiting investments are decreasing in accordance with a high standard of margin of safety. If for instance, you would only be willing to invest in companies that are trading at least at a 50% discount of their fair value, you might have a hard time finding such companies, especially in times where stocks in general tend to become overvalued such as in bull markets.
That being said, having a healthy margin of safety with each investment can be a very favorable requirement for many investors especially value investors.
Conclusion
Investors consider margin of safety to be the difference between intrinsic value and current market price. The most commonly used method for value investors to determine the fair value of a stock is the Discounted Cash Flow Analysis (DCF).
The margin of safety of an investment serves different purposes to the active investor. Applying a margin of safety doesn’t only reduce the potential downside of the stock when the assessment of your analysis doesn’t turn out to be fully right, but it additionally provides you with an exceptional upside to your return, if your estimates turn out to be accurate.
