Margin of safety (financial)

Margin of safety (safety margin) is the difference between the intrinsic value of a stock and its market price..

Another definition: In Break even analysis (accounting), margin of safety is how much output or sales level can fall before a business reaches its breakeven point.

History

Benjamin Graham and David Dodd, founders of value investing, coined the term margin of safety in their seminal 1934 book, Security Analysis. The term is also described in Graham's The Intelligent Investor. Graham said that "the margin of safety is always dependent on the price paid" (The Intelligent Investor, Benjamin Graham, HarperBusiness Essentials, 2003).

Application to investing

Using margin of safety, one should buy a stock when it is worth more than its price on the market. This is the central thesis of value investing philosophy which espouses preservation of capital as its first rule of investing. Benjamin Graham suggested to look at unpopular or neglected companies with low P/E and P/B ratios. One should also analyze financial statements and footnotes to understand whether companies have hidden assets (e.g., investments in other companies) that are potentially unnoticed by the market.

The margin of safety protects the investor from both poor decisions and downturns in the market. Because fair value is difficult to accurately compute, the margin of safety gives the investor room for error.

A common interpretation of margin of safety is how far below intrinsic value one is paying for a stock. For high quality issues, value investors typically want to pay 90 cents for a dollar (90% of intrinsic value) while more speculative stocks should be purchased for up to a 50 percent discount to intrinsic value (pay 50 cents for a dollar).^[1]

Application to accounting

In investing parlance, margin of safety is the difference between the expected (or actual) sales level and the breakeven sales level. It can be expressed in the equation form as follows:

Margin of Safety = Expected (or) Actual Sales Level (quantity or dollar amount) - Breakeven sales Level (quantity or dollar amount)

The measure is especially useful in situations where large portions of a company's sales are at risk, such as when they are tied up in a single customer contract that may be canceled.^[2]

Rare book

Also, Margin of Safety is a rare and out-of-print book written by Seth Klarman, founder of Baupost Limited Partners, a value investing focused hedge fund based in Boston, MA. Copies of his book are considered something of a collector's item and it can regularly be found on eBay or Amazon.com in the $1200-$2000 price range.

References

• Graham, Benjamin. Dodd, David. Security Analysis: The Classic 1934 Edition. McGraw-Hill. 1996. ISBN 0-07-024496-0.
• http://www.businessweek.com/magazine/content/06_32/b3996085.htm
• http://www.worldfinancialblog.com/investing/ben-grahams-margin-of-safety/26/

Notes

1. ^ Yee, Kenton K. (2008). "Deep-Value Investing, Fundamental Risks, and the Margin of Safety". Journal of Investing 17 (3): 35–46. doi:10.3905/JOI.2009.18.1.027. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1265489. 
2. ^ http://www.accountingtools.com/article-metric-margin-of-safet

External links

• http://www.worldfinancialblog.com/investing/ben-grahams-margin-of-safety/26/