Margin of safety in investing is first introduced by Benjamin Graham and then followed by many value investors including Warren Buffet. As per margin of safety principle, value investor should purchase stocks when their market price is lower than their estimated intrinsic value. The difference between estimated intrinsic value of a stock and its current market price is known as Margin of safety.
In other words, by investing in undervalued stocks with higher intrinsic value, you set a margin of safety in accordance to your risk taking capabilities.
The first and only yardstick you need to calculate in order to get margin of safety is the stock’s intrinsic value. You have a number of factors in order to get estimated intrinsic value of a stock such as growth in sales, growth in profit, P/E ratio, operating margin, Price to Book value or P/B ratio and PEG ratio. In addition to all these financial tools available, you can also use factors like company’s management, industry preference, brands, assets and earnings potentials to determine stock’s intrinsic value.
A stock is said to be over-priced if its market price is above the calculated intrinsic value. It’s considered as under-priced when market price is below the intrinsic value of the stock.
This means investors need to buy stocks at a discount to its intrinsic value. The discount provided the margin of safety in case of any correction in share price. In other words, it refers to the comfort level that the investor has in a stock when he buys the stock at a price. It gives you a better chance to earn a profit by buying stock at a bargain price and later selling them at a better valuation. It also protects your investment in case your stock does not perform as you hope.
Example showing calculation of margin of safety in stock investing
If you calculated the intrinsic value of ABC Company’s stock as Rs 50, which is trading at a present market price of Rs 65, then there is no margin of safety in investing. However if the stock price falls below Rs 50, you may consider buying as its falling below the intrinsic value. If you have decided to buy it at Rs 40, then you are getting a margin of safety of Rs 10 (i.e. Rs 50 – Rs 40).
However, in the above example you need to look into the reasons of fall in the share price as it may change the intrinsic value. For instance, if reason of fall in price is due to future earnings or growth, then you should not invest as it will further decrease your calculated intrinsic value of stock.