The margin of safety formula provides a way for investors to calculate a safe price at which to buy a security. This method derives from the value investing school of thought. According to value investing principles, stocks have an intrinsic value and a market value. Intrinsic value is the price they ought to be trading at, while market value is its current price.
Figuring out the difference between these two prices, typically expressed as a percentage, is the essence of the margin of safety formula. Using it correctly can help protect investors from painful losses.
What Is a Margin of Safety?
A margin of safety, as it relates to investing, gives investors an idea of how much margin of error they have when evaluating investments. Making profitable investment decisions is largely about investment risk management. The risk involved in a trade needs to be balanced with the potential reward. In financial markets, taking greater risks often gives the potential for greater rewards but also for greater losses — a concept known as the risk-reward ratio.
There are actually two ways that margin of safety can be utilized. One is in the investing sphere, the other is in accounting.
Margin of Safety in Investing
As it relates to investing, the purpose of calculating a margin of safety is to give investors a cushion for unexpected losses should their analysis prove to be off. This can be helpful because although estimating the intrinsic value of a stock is supposed to be an objective process, it’s done by humans who can make mistakes or inject their own biases. Even the most experienced and successful traders, both institutional and retail investors — all don’t always make the right call.
To try and correct for this possibility, value investors can determine their margin of safety when entering a position.
Expressed as a percentage, this figure is intended to represent the amount of error that could go into calculating the intrinsic value of a stock without ruining the trade. In other words, the percentage answers the question, “By what margin can I be wrong here without losing too much money?”
Margin of Safety in Accounting
In accounting, margin of safety is a financial metric that calculates the difference between forecasted sales and sales at a break-even point. While this has obvious use in a business context, it’s not really applicable to investors.
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Margin of Safety Formula
The margin of safety formula works like this:
Margin of safety = 1 – [Current Stock Price] / [Intrinsic Stock Price]
Example of Calculating Margin of Safety
Let’s look at an example of calculating margin of safety.
An investor wants to buy shares of company A for the current market price of $9 per share. After a thorough analysis of the company’s fundamentals, this investor believes the intrinsic value of the stock to be closer to $10. Plugging these numbers into the margin of safety formula yields the following results:
1 – (9/10) = 10%.
In this example, the margin of safety percentage would be 10%.
The idea is that an investor could be off on their intrinsic value price target by as much as 10% and theoretically not take a loss, or only a very small one.
Now an investor has determined their margin of safety. How might they use this figure?
To provide a substantial cushion for potential losses, an investor could plan to enter into a trade at a price lower than its intrinsic value. This could be done using the calculated margin of safety.
In the example above, say an investor decided that 10% wasn’t a wide enough margin, and instead wanted to be extra cautious and use 20%. They would then set a price target of $8, which is 20% lower than the stock’s estimated value of $10.
Who Uses the Margin of Safety Formula?
The margin of safety is typically used by investors of value stocks. Value investors look for stocks that could be undervalued, or trading at prices lower than they should be, to find profitable trading opportunities. The method for accomplishing this involves the difference between market value and intrinsic value.
The market value of a stock is simply what price it’s trading for at the moment. This fluctuates constantly and can extend well beyond intrinsic value during times of greed or fall far below intrinsic value during times of fear.
Intrinsic value is a calculation of what price a stock likely should be trading at based on fundamental analysis. There are several factors that determine a stock price and the analysis considers both quantitative and qualitative factors. That might include things like past, present, and estimated future earnings, profits and revenue, brand recognition, products and patents owned, or a variety of other factors.
💡 Quick Tip: How to manage potential risk factors in a self directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.
How Investors Can Use Margin of Safety
After determining the intrinsic value of a stock, an investor could simply buy it if the current market price happens to be lower. But what if their calculations were wrong? That’s where a margin of safety comes in. And why it can be very important when investing in stocks.
Because no one can consider all of the appropriate factors and make a perfect calculation, factoring in a margin of safety can help to ensure investors don’t take unnecessary losses.
As mentioned, too, the margin of safety formula is also used in accounting to determine how far a company’s sales could fall before the company becomes unprofitable. Here we will focus on the definition used in investing.
Ideal Margin of Safety
It’s difficult to say if there’s an ideal margin of safety for any particular investor. But we can say that the larger the margin of safety is, the more room an investor has to be wrong — which isn’t necessarily a bad thing. With that in mind, a larger or wider margin of safety is probably better for most investors.
How Important Is the Margin of Safety
With the idea in mind that a wider or larger margin of safety allows for more room to be wrong about investment choices or analyses, it can be fairly important for investors. But it really will come down to the individual investor, who considers their own personal risk tolerance and investment strategy, and how it meshes with their tolerance for being wrong.
While it may be important to a degree, there are likely other factors that eclipse it in terms of overall importance in an investing strategy. For example, investing regularly and often may be more important — but again, it’ll come down to the individual.
The Takeaway
In investing, the margin of safety formula is a way for investors to be extra careful when selecting an entry point in a security. By determining a percentage and placing a discount to a stock’s estimated value, an investor can find a mathematical framework with which they can try to be safer with their money.
It’s relatively easy to learn how to calculate one’s margin of safety. There are only two variables — the market value of a stock and the intrinsic value. Dividing the market value by the intrinsic value then subtracting the result from one equals the margin of safety.
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FAQ
What is the ideal margin of safety for investing activities?
There may not be an ideal margin of safety for investors, but as a general rule of thumb, the wider the margin, the more room they have to be wrong. Therefore, the bigger, the better, in most cases.
Is the margin of safety the same as the degree of operating leverage?
In accounting, the margin of safety refers to the difference between actual sales and break-even sales, whereas the degree of operating leverage is a different metric altogether. So, no, they’re not the same.
What is a good margin of safety percentage?
While there is no hard and fast answer, some experts might say that a good margin of safety percentage is somewhere in the 20% to 30% range.
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