Investing > Complete Guide to Margin of Safety

Complete Guide to Margin of Safety

Margin of safety is a key concept you’ll need to master if you want to understand value investing.

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Updated March 18, 2022

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Do you ever wish that there was a way to ensure your investments won’t end up causing losses?

Of course you do—everyone does. But unfortunately, that’s pretty much impossible. This doesn’t mean that risk-management strategies don’t work—in fact, the way you approach risks is one of the more important elements of your overall investment strategy. 💡

Margin of safety is a very old concept—it’s a risk-management method hailing from the 1930s. Its widespread adoption has more or less defined the face of what we know today as value investing—and it’s a simple, easy-to-implement concept that you need to put into practice if you’re planning on long-term investing.

Sounds lovely, right? Well, pump the brakes for a second. While margin of safety is a very influential concept, it’s also, as we’ve said, a very old concept. It’s not for everyone—short-term traders won’t find it useful, and through the years, we might have stumbled on to a few more effective ways of achieving the same goal this method sets out to achieve.

However, the method is so prolific that it’s already part of the way major institutions and seasoned investors screen stocks, and it simply doesn’t work for modern growth stocks (particularly tech companies). It isn’t a silver bullet, and it won’t magically make you a good investor—but, it is a part of the equation, and you need to know how it works to successfully combine it with other approaches.

Sound good? Let’s jump into it! 👇

What you’ll learn
  • What is Margin of Safety?
  • How to Calculate Margin of Safety
  • Practical Example
  • Margin of Safety in Investing
  • Advantages and Drawbacks
  • Conclusion
  • FAQs
  • Get Started with a Stock Broker

What is Margin of Safety? 👨‍🏫

The margin of safety is a concept that actually encompasses two quite different things. The first version of this concept is a mathematical formula that can be used to calculate the amount of leeway that a company has before becoming unprofitable. This version is often used in budgeting or by accountants 

Essentially, this version of the margin of safety lets you know how much of a disruption a business can sustain before things start to get really messy. If a business has a high margin of safety, it can weather a bad quarter or perhaps even a year. And, if it has a low margin of safety, it might already be in hot water, and will probably take steps to reduce expenses—either by reducing output or by cutting dividends.

The second meaning of the term margin of safety is a concept that is absolutely essential if you want to understand value investing. If you haven’t heard of this before, it’s the brand of investing pioneered and championed by the likes of Warren Buffet and Charlie Munger.

Our primary goal is to educate you on the stock market and to point you in the direction of success. It stands to reason that we’ll be covering the second meaning of the term margin of safety a lot more than the first—but thankfully, we have the time to do both.

How to Calculate Margin of Safety 🧮

The margin of safety is actually quite easy to calculate. The margin of safety depends on two chief factors—current or estimated sales, and breakeven sales or the breakeven point.

Current sales represent the latest possible information regarding a businesses’ sales, represented by a dollar value – if you’re looking to the future, you can use estimated sales. Obviously, this is much easier to calculate if a business has a concrete product – it’s a bit more difficult to calculate with services but still doable.

The breakeven point is a point in which your income and expenses—or in other words, revenue and costs—are equal. At this point, you’re not making a single cent in profit, but you’re not losing money either.

To get the margin of safety, we subtract the breakeven point from current or expected sales for a flat number, or we use a slightly different formula to get a percentage—we’ll explain in the next section.

Margin of Safety: Practical Example 👷‍♂️

To illustrate, we’ll use a hypothetical example. Let’s say that a company, Company A, has sales totaling $450,000. It also has a breakeven point of $300,000. So, in order to calculate the margin of safety, we subtract $300,000 from $450,000 to get a margin of safety that is equal to $150,000.

Now, the margin of safety can also be viewed through the lens of percentages. Using the same example, to get a percentage representing the margin of safety, we subtract the breakeven point from current sales, divide the resulting number by current sales, and multiply by 100.

In our case, that would look like this: $450,000—$300,000 / $450,000 x 100 = 33.3%—which would give our hypothetical business quite a bit of breathing room should sales be disrupted in any way.

Margin of Safety in Investing 💰

However, a much more influential version of the concept of the margin of safety also exists—and it is often used by investors looking to minimize downside risk when investing in value stocks to be held for a longer term.

Put simply, the margin of safety is the difference between a stock’s intrinsic value and its market value. In order to minimize risk, your aim is to purchase stocks whose intrinsic value is greater than their current market value—for whatever reason.

There’s no golden rule as to how much of a margin of safety is good—you’ll have to figure out how much works for you. On top of that, everyone has a different approach to calculating intrinsic value—it’s not a well-defined metric.

However, one thing is certain—the larger the margin of safety, the longer it will take to realize your profits. If you’re not in a rush, this is great—Warren Buffet, for example, looks to buy stocks at as much as a 50% discount if possible.

Let’s use an example—a stock is currently trading at $100, but your estimation is that its fair, intrinsic value is $80. Obviously, you won’t purchase it at its current price—but you won’t purchase it at $80, either, as you’d end up breaking even, not having made a single dollar.

Instead, you apply the margin of safety—let’s say you aim for a margin of 25%. With that margin of safety, the price you would try to acquire the stock at would be $60. Now, this might take years—but if you keep monitoring the stock, and its fundamentals don’t drastically change in the meantime, if it does hit that price point, you can confidently purchase it, knowing that you have a substantial margin of safety in place to reduce risk.

Margin of Safety and Value Investing 📉

Although the margin of safety as a concept has fallen out of fashion as of late, it’s actually deeply tied to the origin of value investing as we know it today. 

The most staunch and famous value investors, Warren Buffet and Charlie Munger were actually disciples of Ben Graham, who is often referred to as the father of value investing. It was Ben Graham who coined the very term margin of safety in his 1934 book, Security Analysis, co-written with David Dodd.

In the words of Munger and Buffet, Graham’s approach consisted of taking his “Geiger counter” (which is to say, his approach to calculating intrinsic value) and taking it across the rubble of the 1930s securities market. This, as we can see from how well his career went, worked marvelously—but conditions change, and as we’ll see later, this approach might not be as useful today as it was 90 years ago.

Advantages and Drawbacks of Using Margin of Safety 📝

Right—now that we’ve dealt with the basics, let’s move on to something that’s a bit more practical. The margin of safety, as a concept, has both advantages and disadvantages—although to be perfectly frank, a lot of the time it’s simply a question of whether or not the approach works for your specific needs.

Margin of Safety and Growth Stocks 📊

One of the biggest drawbacks of using margin of safety in the non-value investing way—i.e. as a calculation of profitability and the break-even point is that this approach is entirely unworkable when it comes to growth stocks.

And you’re probably aware by now that growth stocks are the stars of the show when it comes to jaw-dropping returns. Put simply, the margin of safety cannot take into account the potential for growth that is spurred on by investor confidence and cutting-edge technology that could end up giving the company an economic moat.

We’ll use a nice, obvious example—a company that fits the bill to a T and that’s often mentioned in the news—Tesla. If you were to look at Tesla only from the perspective of the margin of safety, you could quite easily come to the conclusion that it is a struggling business, and that the stock price will plummet any day now.

But it hasn’t—and it probably won’t. Tesla’s success isn’t due to a large volume of sales—it’s due to people’s expectations that the quality of their products, the competence of the managers, and the advantage of their research and development will eventually result in a large volume of sales.

Margin of Safety and Growth Stocks
Very innovative tech companies often earn investor confidence because of their research despite having poor fundamentals. Image by TradingView.

Now, let’s be fair—growth stocks are much riskier and more volatile than value stocks. In fact, comparing growth investing and value investing is sort of like comparing apples to oranges. But the fact remains—this is a lens that can only be used to gauge the quality of a certain type of stock, so it is a bit inflexible and lacking overall.

Investment Timeframe ⏲

As a core tenet of value investing, the margin of safety is one of the most common approaches that is taken when it comes to long-term, buy and hold investing. But can it work with other investment timeframes—for example, can it be utilized in trading?

The short answer is no. Even by the standard of buy-and-hold investing, this particular brand of value investing might take years to play out. The common rule of thumb used for buy-and-hold investing of not touching your investments for five years at the least is far too lax when using the margin of safety.

Essentially, to utilize the margin of safety like its pioneers intended, you’d have to buy a stock at a huge discount. There’s no guarantee that it will ever reach a price point that reflects its intrinsic value—and it does, it’s probably going to take a very long time.

The margin of safety, and value investing in general, is neither quick nor particularly profitable—it is, at its core, a risk-management strategy aimed at reducing downside risk. If you don’t have the patience to wait out the long period that is required to see the fruits of this approach, don’t even try it. 

Because of its relatively modest returns, we recommend allocating a certain amount of your portfolio to value stocks picked using this method. But don’t go overboard with safety, or you won’t even be able to secure returns that are average for the stock market.

Common Knowledge 📚

One of the caveats of the margin of safety is that it is, to put it plainly, a rather outdated and played-out approach. While it was revolutionary in the 1930s, by now, the tenets of margin of safety that have proven to hold true are so widespread and universally adopted that applying them doesn’t really give you an edge.

And this isn’t news—in fact, Munger and Buffet are on record as having said that the approach is mostly common knowledge now. Even if you take into account factors such as low price to earnings, low price to book—these are all commonly mentioned indicators of a good value stock.

Return on Investment and Risk ⚖

As we’ve already mentioned, the margin of safety is primarily a risk-management tool. The goal of this method is to reduce downside risk—not to secure huge gains. While the reduced risk might appeal to more conservative investors, the fact of the matter is that the returns that you can get using this method simply won’t be good enough for a lot of investors.

In particular, just like it is the case with value investing, younger investors who have more risk tolerance—that is to say, more time to make up for any losses—should instead stick with growth stocks and other investment methods.

On the other hand, if you’re in your 40’s, 50’s, or nearing retirement age, the margin of safety can be a great way to find safe, undervalued stocks for long-term holding.

A Closer Look at Ben Graham 🕵️‍♂️

Although he was a trailblazer and mentor to some of the most influential investors in the last 60 years, even Ben Graham’s own results with using the margin of safety were… sort of questionable.

Graham published four editions of “The Intelligent Investor”—with the fourth edition being released in 1973. In it, he admits that more than half of his returns weren’t acquired by using the margin of safety and the net-net method, but instead, they were due to a single stock. Can you guess what that stock was?

It was Geico—a recognizable, household name—and probably the first thing that comes to mind for our U.S. readers when they hear the words car insurance. Geico had a competitive business with an unbeatable price, which allowed the company to rapidly expand and grow. In short, it was a growth stock.

And that might be the best way to round out today’s topic. Over half of Graham’s returns were due to a single stock that belonged to a good, high-quality business that had a significant advantage over the competition. This was also noticed by then 21-year old Warren Buffet—who would go on to put more weight on factors such as competitiveness rather than the margin of safety in his own approach to value investing.

Conclusion 🏁

Congratulations on making it to the end. We’re well aware that this isn’t the most riveting of topics—both the formulas and calculations and the elusive concept of “intrinsic value” aren’t really stuff that will keep you glued to your screen.

Be that as it may—it might not be the most interesting stuff in the world, but it is important. Even if you’re a young investor hot on the trail of the latest growth stock sensations, value investing is something that’ll play a role in your financial future—sooner or later. It pays to be familiar with it on time.

Margin of Safety: FAQs

  • Is a High Margin of Safety Better than a Low One?

    When it comes to calculating break-even points, a high margin of safety is always better than a low one. A high margin of safety lets a business easily weather recessions, increasing production costs, and a myriad of other possible occurrences that could otherwise disrupt business.

    When it comes to value investing, a high margin of safety means that you’re exposing yourself to less risk—but this, in turn, means that the odds of high returns are slimmer. On top of that, the higher the margin of safety, the longer it will take for the stock to reach your price target.

  • Can the Margin of Safety Be Negative?

    Yes—a negative margin of safety indicates that a business is experiencing losses—in other words, that business is no longer profitable. A negative margin of safety is a very bad sign, and generally cannot be sustained for longer periods.

  • How Important is Margin of Safety?

    The margin of safety is an essential concept in the realm of value investing. However, if you’re not planning on using this approach, it won’t be as important a metric.

  • Is Margin of Safety Equal to Profit?

    No - the margin of safety isn’t equal to profit. It is the difference between expected sales or profits, and the breakeven point.

  • What Does a Higher Margin of Safety Mean?

    A higher margin of safety means that a business is in a better position to weather reduced sales. In essence, a business with a high margin of safety is more resilient to worsening market conditions - it’s a much safer choice than a stock with a low margin of safety.

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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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