There are various fundamental principles in value investing, and margin of safety is one of them. With margin of safety, investors only buy assets when their market price is below their intrinsic value. Or rather, margin of safety in accounting is the difference between your actual sales value and the break-even point. It is any revenue earned for sales above the break-even point after factoring in a company’s fixed and variable costs.
We prepared this guide to help you understand margin of safety in investing and the formula involved. As an investor, you should be able to avoid engaging in a scenario where there is little to gain and more to lose in an investment.
In This Guide
What is the Margin of Safety Formula?
Understanding Margin of Safety
As mentioned above, margin of safety is the principle that allows investors to purchase assets when the market price is below their actual value. This investment principle mostly applies to stock investments and protects investors against market downturns.
Note that investors using margin of safety can set it depending on the risk level. You will consider various factors to determine a stock’s intrinsic value, including market performance, company management, earnings, governance, etc. With actual market price as a comparison point, you will then calculate the margin of safety.
That being said, here is a summary of the methods investors use to calculate a stock’s intrinsic value.
- Multiples: With this method, you will compare a company’s stock with its competitors’ using multiples such as price/sales, price/earnings, and price/book. The multiples can also help you compare a stock’s market or its historical numbers.
- Discounted Cash Flow: Here, you project the future cash flow of an investment and then discount the numbers. This allows you to arrive at a fair market price, which will be your intrinsic value.
- Liquidation Value: This model allows you to determine the value of a company when its assets are sold.
Stocks’ intrinsic value may vary depending on your analysis. The higher the margin of safety, the less risk an investment will experience. For instance, if one stock has a 15% margin of safety and another has 30%, consider the one with 30% because it has a higher probability of falling less than that with a 15% margin of safety. Simply put, only participate in value investing when its margin of safety is above 20% for maximum safety.
Benefits of Margin of Safety
Margin of safety is used to prevent possible losses in investments so you can maximize returns. As an investor, you may apply this strategy using a company’s current market price to understand its share value. Ensure your analysis is extensive so you can get the exact variance to use as a basis for purchasing the stocks. There should be potential growth in a company’s stock prices to guarantee returns.
In businesses, margin of safety helps a company understand its existing cushion before it becomes unprofitable. For instance, let’s say company A’s current sales are valued at 6,000 units, with an estimated break-even point of 5,500. In this case, its margin of safety will be 500 units, allowing you to strategize ways to reduce the risks of the business becoming unprofitable. A low margin of safety means higher risk for the business, and you must cut off some budgeted expenses to mitigate the risks. Also, ensure you find ways to boost your sales and recover from this downturn.
Calculating Margin of Safety
For Investors
To calculate a stock’s margin of safety, you will first need to determine its intrinsic value. This process can be subjective and complex since you must apply various approaches, most of which require predicting a company’s level of risk and its future cash flow. Besides accounting for a company’s risk, investors must also consider the probability that a stock market might altogether decline. Also, note that your calculation for determining a stock’s intrinsic value might be wrong, thus leading to an inaccurate margin of safety.
That being said, here is how to calculate margin of safety in value investing.
Margin of safety = 1-[Current market price ➗ intrinsic value] x 100
For instance, company ABC stocks current market price is £300, and you believe, based on your analysis, that its intrinsic value is £500. This means that its margin of safety will be 40% based on the formula above.
In Accounting
As mentioned earlier, margin of safety in accounting is the difference between the break-even point and the amount of expected profitability.
Margin of safety = [estimated sales – break-even sales] ➗ estimated sales x 100
For instance, if your company’s estimated revenue for the year is £300,000 and has a break-even sales of £200,000, your margin of safety will be as follows:
MOS = [£300,000 – £200,000] ➗ £300,000 x 100
MOS = 33%
Margin of safety may help you account for multiple risks, but it doesn’t guarantee returns. You must thoroughly conduct your analysis for maximum potential. Besides being expressed in fiat currency, margin of safety can also be calculated in units. Therefore, always be keen on the figures provided to get accurate findings.
Margin of Safety and Investing
Losing money is an inevitable part of investing. However, as a sensible and intelligent investor, you must implement measures to avoid incurring losses. The margin of safety is an excellent risk-management strategy to cushion against significant losses while maximising returns.
A margin of safety investment plan begins with analysing risks before looking at potential returns. Depending on your risk appetite, you can set different levels of margins of safety. For example, if you feel that a stock is selling for 25% less than its intrinsic value and you are confident that it has plenty of room for growth, then, by all means, buy the stock.
However, suppose you want to invest in stocks in highly volatile sectors. In that case, it may be wise to focus on the ones with higher margins of safety to accommodate the higher level of uncertainty involved in the investment.
FAQs
In businesses, accountants calculate margin of safety to help managers understand the number of sales that will decrease before a company becomes unprofitable. For investors, margin of safety helps them determine their “room for error” or cushion period for poor decisions or downturns in the market.
Margin of safety increases if variable costs decrease. The higher the margin of safety, the lower the risk of incurring losses in an investment and vice-versa. Companies can use margin of safety to understand the number of sales and increase them before becoming unprofitable.
You can use margin of safety formula in trading to determine whether an asset is worth investing in during a particular period. It helps you understand the risks in an investment, thus making the best decisions.
You first need to determine a stock’s intrinsic value to calculate margin of safety. Therefore, thoroughly conduct your analysis by comparing various factors, including predicting a company’s level of risk and its future cash flow. Once you identify your intrinsic value, you can easily get the margin of safety by finding the difference between a stock’s current price and its intrinsic value. See our guideline above for the margin of safety formula.
A good margin of safety should be around 20-30%, so you get enough room for error. The higher the margin of safety, the lower the risks of making losses and vice versa.
A high margin of safety is better than a low margin of safety because it leaves room for cost increases, downturns and errors for investors. In businesses, a high margin of safety gives you an opportunity to change your level of sales before the business becomes unprofitable.
Yes. A stock with a 50% safety margin is considered good as it is likely to drop less value than a stock with a lower or no safety margin. It’s also unlikely for any high-quality company to lose more than 50% of its value.
Margin of safety can be expressed as a percentage. It’s also often expressed in units of goods sold and sales dollars.
Absolutely. Investing in a stock with a higher margin of safety is always desirable because it can reduce the risk of a substantial loss. However, it’s worth noting that the right margin of safety depends on your investing style and risk tolerance. If your goal is to minimise risk, a margin of safety of 20% or higher may make sense. If you’re concerned about growth, you can use a slimmer margin of safety.
Conclusion
Margin of safety is an excellent option to mitigate investment risk if you do not want to engage in stock shorting or buying put options. However, you must be keen with your analysis and ensure an asset’s margin of safety is around 20-30% so you can have enough “room for error.” This means that you have a safety cushion or period to recover in case you are wrong with your analysis. Simply put, the larger the margin of safety, whether in value investing or accounting, the more room you have for error.
When considering to buy a margin, always maintain a sufficient margin of safety to protect your investment and allow for potential fluctuations.
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