What is Margin of Safety and its importance?

11 Aug 2020  Read 2087 Views

I have encountered people who are extremely cautious and value safety above all. Being safe is so important to them that they sanitize their food before eating it. Unfortunately, it seems they don't invest. If they had, they would strictly follow the Margin of safety, unlike most investors. The Margin of safety is the concept where investors buy well below the intrinsic value of their stocks to avoid any loss. ok, now what about it? Learn more to figure out,

Margin of safety with an example

In accounting terms, the Margin of Safety is the sales which the company would afford to lose before it actually accumulates loss. It is the reduction or loss in sales before reaching the break-even point. Managers use this concept to make informed and calculated decisions for the success and profit of the company. 

But as far as investing is concerned, the Margin of safety, simply put in, is the difference between the current market price of a particular security and the intrinsic price. Here, you will be investing in an undervalued asset and, at a price lesser than its intrinsic value.

Take a look at this example. You are climbing a mountain. You are a very good climber, and the chances in which you might be falling down are slim. But still, you attached yourself to safety gear in order to be safe if you had to fall. Unfortunately, the winds were strong on that particular day, and you were pushed down. 

Stock markets are familiar with such incidents. Despite taking calculated steps and measured investments, you can still be a loser if the winds are not backing you up. So an investor will want to save his head from all such shortcomings as much as possible. 

Hence, he will buy the stock at a discount or at a price which is lower than its calculated intrinsic value so that you can offset the unforeseen losses which are accumulated due to reasons which are out of your control or due to mistakes of your own. 

How do you calculate the Margin of safety? 

Consider a case where a stock is trading at a price of Rs.50. But the stock has the potential to perform better in the future and is simply undervalued. Assume the stock has an intrinsic value of Rs.100. Mr. A invested in the stock when the price was 60, and Mr. B invests when the price is 110. Now say the markets are facing a tough time, and there is high volatility. As a result, the prices fell to Rs.90. In such a case, A will have a safer ground than B. Hence A has a margin of Rs.40 as his safety line. The Margin of safety can be calculated as follows, 

The margin of safety = 1- (the current trading price of the share / its intrinsic value) 

While the above formula is effective in removing at a conclusion, the Margin of safety differs from individual to individual. Because a person's Margin of safety might basically depend on their risk profile. A young working professional can boldly take a risk by reducing his Margin of safety while a retired man will need a wider margin. However, a higher Margin of safety offers a better shot at a profit and a lower chance of losing your capital. 

Ultimately the challenge exists in picking the right stock and investing at the right price. Just because a stock is priced low, it need not necessarily translate into a good stock. So picking the right stock, which is undervalued, is essential in making a fortune. A few metrics like low P/E ratio, low P/B ratio, high dividend yield, etc., will help determine if or not a stock is undervalued. 

chart explaining Margin of safety

Warren Buffet's Bridge Analogy 

Introduced by David Dodd and Benjamin Graham, it has become an important parameter for any investor when it comes to picking up or buying up stock. Nothing can better explain the concept than listening from the master himself. Warren Buffet believes that this is the most essential concept. He compares this with the example of a bridge. Say a bridge is constructed in such a way that it can carry only 30,000 pounds. But you move one step forward and allow trucks which are only 10,000 pounds, to be on the safer side. Likewise, you prioritize safety by investing at a price lower than the actual value. 

Why is the Margin of Safety important?

Everyone loves a discount. We usually flock to stores when a discount is put up. Similarly, buying a stock when it is at a discount not only gives you an opportunity to bag a good stock at a reasonable price but also helps in acting as a cushion if their judgment goes wrong. Hence you will be able to limit losses and reap maximum benefit from the investment you are making. A few other reasons as to why you should consider Margin of safety are as follows, 

  • The price of the stock or its intrinsic price is determined by considering various financial factors. However, just as the numbers, the management, operations, corporate governance, etc., play a crucial role in determining the intrinsic value. The Margin of safety helps you to insulate yourself against any probable losses if your verdict is wrong. 
  • Say you are doing a fine job balancing your assets. But the sudden trade war between country X and Y caused the markets to fall. In such a case, the Margin of Safety will be your armour. So when the prices fall, you can still enjoy the safety of capital. 
  • Acts as a defense shield against the human factor's ups and downs, which is inseparable from the market. For instance, herd behavior. Say Hindustan Unilever Ltd launched a new product line. In such a case, the market might be highly optimistic about it. You might follow the track and might end up losing your money. Even in cases like that Margin of safety teaches you as an investor to not only look at the returns but also try and answer the question "what is the risk you are signing up for?"

No one is going to like losing their hard money as a result of some wrong calculations. So its high time you start looking beyond profits and see what is at stake. 

Final thoughts

In a time filled with high volatility, a Margin of Safety is like a helmet, which will reduce the risks. While the entire world is running behind safety, it's high time we ensure safety in our investments as well. So even if you have a nasty fall, you will at least have a safe landing. 

About the Author: Varishika Dinesh | 70 Post(s)

Varishika is on the verge of successfully completing B.Com. Nothing excites her more than reading books and watching movies. Business, finance, economy? You have her attention.

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