Margin of safety: formula, definition and importance

17 sierpnia 2022

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Margin of safety: formula, ...

An investment is always a risk. You can make a lot of money, but you can also lose it. Fortunately, the science of finance has created a number of tools designed to minimize capital losses. One of them is the margin of safety, a formula defined by an important London investor named Benjamin Graham, the promoter of value investing.

Benjamin Graham, in 1949, published a successful book entitled "The Intelligent Investor", where he devoted an entire section to the analysis of how the margin of safety is calculated. Certainly, his ideas have become one of the most accurate guides for those who work in the financial activity, all thanks to the correspondence that his postulates have with mathematical accuracy.

In what follows, we will explain what the margin of safety is and how to calculate it, through different examples. In short, you will learn why the margin of safety is important for your business and why you should take it into account.

Definition of margin of safety

To define the margin of safety, the financial formula used by investors to calculate their probabilities of success, we must point out that this is the result of a transaction where the quoted price of an asset differs from its real value. In other words, it is the difference between the so-called intrinsic value and its fluctuating market price.

As we can suspect, the wider the gap between these figures, the lower the risk rate that the margin of safety formula yields in the face of unpredictable market jumps. The result of this operation will almost always contrast with the intrinsic value of the asset or the company, since it obviously depends on multiple factors.

Importance of the margin of safety

The investment world is a space where those who are not fully prepared run the risk of losing a lot of money. Of course, anyone who commits his capital in shares intends to multiply it in a profitable operation. The margin of safety formula, in this scenario, is useful to identify which companies are currently undervalued (commercially speaking), but which can become important sources of income in the long run.

Therefore, knowing how to calculate the margin of safety is a protective shield against different risks. Let's take a look at some of them:

Unexpected changes within the company.
Unforeseen events in the commercial sector to which the business belongs.
Economic crises.
Miscalculations regarding predictions about the value of a certain stock.

The margin of safety principle

As hypothetical values, these estimates depend on multiple factors, many of them circumstantial, and which in the end will determine the three types of quotations that are derived from the so-called margin of safety, how it is calculated, etc.

Highprice: This occurs when the price of the financial security exceeds its intrinsic value.

Fair price: It is when the price and the intrinsic value of the financial security, if not equal, are quite close.
Downwardprice: This is when the price of the financial security is well below its intrinsic value.

As we can see, the margin of safety formulates how it is calculated to favor the investor, since it usually derives in important royalties. However, we cannot forget that economics is a science that depends on many factors, most of them human, so any prediction we can make about the price of an asset must always be a rough estimate.

Logically, the principles of value investing are governed by the idea that the investor has a green light only to buy shares of companies that are cheap and have growth potential, a necessary condition to consider that an injection of capital is taken intelligently. But how to make this margin of safety calculation?

Formula or calculation of the margin of safety

Below is the formula for calculating the margin of safety:

Margin of safety = [ 1 - (Market price / Intrinsic value) ] x 100

It should be clarified that the result of this calculation is expressed as a percentage (%), so it is closely related to the value quotation. If this figure yields the number 40, we must understand that the appraisal corresponds, at the time of the transaction, to a 40% discount in relation to the intrinsic value.

To tell the truth, the application of this formula is quite simple. The challenge, in fact, is to get the market price and the intrinsic value right, so that the result ends up being as accurate as possible. To do this, other valuations will have to be taken into account, such as the discounted cash flow and the relative valuation of the stock.

Example of margin of safety

Let's imagine a hotel business whose shares are valued, today, at USD 60 each. In order to know whether it is relatively safe to invest in them, it is also necessary to know their intrinsic value, derived from the analysis of the accounts of the last fiscal years. After this calculation, let's imagine that the real value of the shares is USD 90:

Margin of safety = [ 1 - ($60 / $90) ] x 100 = 33.3%.

In summary, we can assure that the supposed hotel business is trading 33.3% below its real valuation, so it would be a good opportunity to invest in a company whose business always aims to have good projections.

In conclusion, it is important to point out the following: a high margin of safety does not guarantee the possibility of not losing capital in this type of business. Therefore, we insist that this tool is designed to minimize financial risks, not to avoid them. There are many hypotheses in these operations, although in general, if they are well founded, they do not usually fail.

In other words, these calculations were designed to control the impulsiveness of the investor, who is not always familiar with the fluctuations of the stock market, and thus protect his capital. For the same reason, our recommendation is always to invest in stable trades that project positively over time.

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