InvestorQ : What do we understand by margin of safety in investing?
manisha Kolvenkar made post

What do we understand by margin of safety in investing?

Mahima Roy answered.
3 years ago

Margin of safety in investing is a concept that was first propounded by Ben Graham, who is considered to be the father of modern investment theory. The concept has been applied at length by Warren Buffett and has been one of his key driving factors over the last many years of his successful investing career. Margin of safety, as the name suggests, refers to the comfort level or the cushion that the investor has in a stock when he buys the stock at a particular price. According to Buffett, most stocks would be worth buying if the price is right. Now let us understand the concept of margin of safety with reference to the intrinsic value of the stock.

Margin of safety is always with reference to the intrinsic value of the stock…

A stock’s intrinsic value is a function of a variety of factors. There are financial factors like growth in sales, growth in profits, operating margins, P/E ratio, dividend yield etc. Then there are non-financial factors like the management quality, entry barriers created by the product, corporate governance standards, brands and other intangible assets of the company. The final valuation is arrived at by combining the impact of financial and non-financial factors. It is normally arrived at by discounting future cash flows and then adjusting it with the peer group P/E ratio and other qualitative factors. The output is the intrinsic value of the stock.

The intrinsic value is actually useful if looked at with reference to the market price of the stock. A stock is said to be underpriced if the market price is below the intrinsic value and it is considered to be overpriced if the market price is above the intrinsic value. But the big question is by how much is the stock overpriced or underpriced. This gap between the market price and the intrinsic value is referred to as the margin of safety. From an investor’s point of view, if the market price is substantially lower than the intrinsic value of the stock then the stock offers a high margin of safety and it is a good stock available for investment at an attractive level. On the other hand, from a seller’s perspective, if the market price is substantially higher than the intrinsic then it offers a higher margin of safety to sell or short the stock. Thus margin of safety works both ways, although it is popularly used to refer to a situation when stocks are deeply underpriced.