By Malvika Saraf and Parthajit Kayal
In the principle of investing, the margin of safety is the difference between the intrinsic value of a stock against its prevailing market price. Intrinsic value is the actual worth of a company’s asset or the present value of an asset when adding up the total discounted future income generated.
In other words, when the market price of a security is significantly below one’s estimation of its intrinsic value, the difference is the margin of safety. Because investors may set a margin of safety according to their own risk preferences, buying stocks with margin of safety allows an investment to be made with minimal downside risk.
Understanding margin of safety
The margin of safety principle was popularised by the British-born American investor Benjamin Graham, who is also known as the father of value investing. Investors utilise both qualitative and quantitative factors, including firm management, governance, industry performance, assets and earnings, to determine a stock’s intrinsic value. The market price is then used as the point of comparison to calculate the margin of safety. Considering a margin of safety when investing provides a cushion against errors in analyst judgment or calculation. It does not, however, guarantee a successful investment, largely because determining a company’s “true” worth, or intrinsic value, is highly subjective.
Investors and analysts may have a different method for calculating intrinsic value, and rarely are they exactly accurate and precise. In addition, it’s notoriously difficult to predict a company’s earnings or revenue. The fair market price of the security must be known in order to use the discounted cash flow analysis method then to give an objective, fair value of a business.
Example of investing and margin of safety
We know that a stock priced at Rs 100 today could just as likely be valued at Rs 50 or Rs 150 in the future. We also recognise that the current valuation of Rs 100 could be off, which means we would be subjecting ourselves to unnecessary risk. It can be concluded that if we could buy a stock at a discount to its intrinsic value, we would limit our losses substantially. Although there was no guarantee that the stock’s price would increase, the discount provided the margin of safety we needed to ensure that our losses would be minimal.
For example, suppose we were to determine that the intrinsic value of XYZ’s stock is Rs 162, which is well below its share price of Rs 192, we might apply a discount of 20% for a target purchase price of Rs 130. Here, we may feel XYZ has a fair value at Rs 192 but we would not consider buying it above its intrinsic value of Rs 162. In order to absolutely limit our downside risk, we set our purchase price at Rs 130. Using this method, we might not be able to purchase XYZ stock anytime in the foreseeable future. However, if the stock price does decline to Rs 130 for reasons other than a collapse of XYZ’s earnings outlook, we could buy it with confidence.
How much 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 choose. 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%, an aggressive risk profile investor would be okay with a 10-20% margin of safety.
To sum up, it pays to be conservative and balance downside risks with expected returns. By using the margin of safety concept, and refusing to pay too much for an investment, one can mitigate the chances of wealth disappearing. As investors, we do not need to endlessly strive for precision. Just being approximately right while having a good margin of safety is sufficient to get the job done.
Saraf is a recent graduate, Madras School of Economics and Kayal is assistant professor, Madras School of Economics