Margin of Safety

Introduction

Do you want to protect your gains in the stock market? Are you trying to buy stocks with minimum downside risk? Studying the margin of safety before making stock investments is beneficial. It helps in understanding the gap between the prevailing stock price and its intrinsic or actual value. During times of extreme volatility, the margin of safety acts as a built-in cushion to reduce your losses in the stock market.

Understanding the margin of safety in stock investments

Many renowned investors have applied this concept numerous times over years, and it has been one of the key driving factors behind their prosperous investing career.

The margin of safety uses quantitative and qualitative factors, such as assets and earnings, competitive advantage, corporate governance, industry performance, and more, to estimate a stock’s actual or intrinsic value.

In other words, the margin of safety refers to the purchase of shares when their market price is lower than their intrinsic value. For instance, investing in the stocks of a company with a strong foundation and corporate governance may not be a good idea if done at a very high price. It is because the stock price has already risen so high that there is limited room for profit.

Importance of margin of safety

Using the margin of safety formula is necessary due to the following reasons:

• Many valuations depend on assumptions. While empirically tested methods are used to derive the assumptions, there is scope for error. Thus, maintaining a higher level of margin of safety protects the investor from such divergences in valuations.
• Today, unexpected changes are common. The stock market is under the influence of many local and global risk factors that are not in the control of traders and investors. Thus, stock prices are also volatile. Besides, changes in interest rates, etc. can change a stock’s economics, thereby affecting its intrinsic value. With a higher margin of safety, investors can remain protected against such vagaries.
• Mistakes are common during investing. You can go wrong in estimating the company’s potential or the right entry point for a stock. With a higher margin of safety, you can enjoy better protection even after committing such mistakes.
• Margin of safety protects investors against unknown unknowns. Investors can gauge some risks, but there are some that no one can recognize. Many noted investors refer to these risks as the unknown unknowns. The concept of margin of safety helps in handling risks efficiently. By investing in stocks whose price is significantly lower than their intrinsic value, you can easily beat the odds.

Margin of safety formula

Conceptually, the formula for the margin of safety can be the difference between the intrinsic or true value and the current share price.

The following margin of safety formula can be used for estimating a purchase price:

Preferred price to purchase a stock = Intrinsic value of a stock *(1- Margin of safety)

For example, the current price of a company’s shares is Rs. 100, but the investor estimates the intrinsic value at Rs. 90. In this case, the stock is trading above intrinsic value and a 10% fall in stock price makes the stock to trade at its intrinsic value. If the margin of safety is 30%, the investor prefers to purchase a stock at 90*(1 - 0.3) = Rs. 63, i.e. 37% below its current market price.

What is a satisfactory level for margin of safety?

The margin of safety you should maintain depends on your risk tolerance and preference. Furthermore, it depends on the stock’s risk grade. For example, the margin of safety for a blue-chip stock can be lower than for small-cap and midcap stocks.

The margin of safety is also dependent on the type of investor. For a growth investor, a margin of safety of 15% to 25% is adequate, whereas a value investor will need a margin of safety of around 40% to 50%.

You can choose your own margin of safety as per your profile. There is no universally accepted method to calculate the intrinsic value of a stock. However, it is often estimated by discounting the cash flow method or comparable analysis method. Discounted cash flow method uses a lot of variables like future cash flow, cost of capital etc.; this number may not be the same for all. A simplistic method to find the intrinsic value is using ratios like Price to earnings (P/E), where you can calculate the intrinsic value by multiplying the EPS by the industry's average P/E. If a stock's EPS is 20 and the industry's average P/E is 30, then the intrinsic value of a stock would be 20*30 = Rs.600.

It is vital to understand that margin of safety is only an estimate, and it requires good practice to get it right. Using the margin of safety formula, investors can select stocks of firms that they prefer to invest. As a result, the stock is better than the stock of peer companies. This concept also works well for companies with an economic moat. If you buy a company's securities with an economic moat at a price below the estimated intrinsic value, it may help you increase your returns in the long run.  

Conclusion

To sum it up, the margin of safety helps you become a patient investor who purchases the right stocks at the right price. Even you can avoid buying quality stocks at any price and prefer to wait till it reaches your target price. 

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