What is Margin of Safety?
The term margin of safety refers to an investment purchased at a deep discount from its assessed value.
The thinking goes that purchasing an investment for less than it is worth reduces an investor’s chance of losing money and should allow the investor to sell at a higher price.
Margin of safety is a value investing principle first popularized by Benjamin Graham in his book Security Analysis and later expanded upon in his successive publication, The Intelligent Investor.
When Does a Margin of Safety Exist?
A margin of safety exists when an investment is available for purchase for less than it is worth.
That seems straightforward, but it can actually be quite tricky to determine, because the value of a business is inherently subjective.
Investors attempt to determine what an investment is worth by calculating a business’ intrinsic value.
There are many ways to calculate intrinsic value, including discounted cash flow analysis (DCF), financial multiple analysis, and the sum-of-the-parts (SOTP) method.
Using the SOTP Method
Let’s take the sum-of-the-parts valuation method as an example of margin of safety.
If a company owns real estate worth $100 million, has a cash balance of $50 million, and has no debt or other liabilities, then the sum of its assets equals approximately $150 million.
If for whatever reason the company’s stock trades at a price implying a $100 million valuation, an investor could buy the stock at a discount from its intrinsic value based on the sum of its parts.
However, stocks tend to trade at a discount from their intrinsic value for a reason.
A company like the one described in the prior example may have very poor leadership with a track record of draining resources and destroying value. It is also possible the company could be subject to an off-balance-sheet liability, such as a lawsuit that doesn’t yet appear in the financial statements.
The bottom line is that investors should be careful when analyzing companies that appear to have a large margin of safety.
Something that appears too good to be true often is.
But if an investor does identify a company with downside protection in the form a margin of safety, an investment could produce a win-win outcome.
MOS and Investment Decisions
Value investors are a subset of investors who seek to buy businesses at a discount from their assessed value or intrinsic value.
The deeper the discount at which an investor can buy a business, the greater their margin of safety on the investment is.
“Buy low, sell high” is a common phrase in the investment world that primarily refers to price, but another way to think about buying low and selling high is to think about value.
If a stock trades below its intrinsic value, according to an investor’s own assessment, the stock may be considered “undervalued” and it may be a buying opportunity as shown in the graphic above.
The flip side of that coin is that a stock may be considered “overvalued” if it trades above its intrinsic value.
Unlike the graphic above, intrinsic value is rarely a static measure.
Intrinsic value tends to change over time depending on a company’s changing competitive position, growth rate, and profitability.
This causes investors to constantly rethink what a company is worth and how attractive stock prices are at different points in time. If the intrinsic value declines over time, the margin of safety diminishes, and vice-versa if the intrinsic value of a company increases.