Margin Of Safety

The margin of safety is the difference between the intrinsic value of a security and its current market price.

Benjamin Graham and David Dodd coined the term “margin of safety” in their 1936 book., Security Analysis. It was also featured in Graham’s The Intelligent Investor.

Value investing, which was first described by Graham and Dodd, seeks to buy companies at a discount to their intrinsic value. But a company’s intrinsic value, which judges not just the current value of the company but the future value of the company, depends on several variables that can at best be estimated. Therefore, the value investor builds in a margin of safety: the difference between the company’s intrinsic value and the market value that would have to exist before the value investor would trust that he or she was truly buying at a discount.

For example, in order to buy a particular security, an investor might require that the market price be 30% below the intrinsic value. This margin of safety would ensure that, even if his calculated intrinsic value were wrong, he would likely not have overpaid.

The margin of safety, in other words, is a way of managing the risk inherent in valuing and buying securities. Investors will often require a smaller margin of safety from an established company with a competitive advantage, for example, than for one in a new and growing industry. As Warren Buffett once quipped, “It is better to be approximately right than precisely wrong.”

Example

If shares of Danneskjöld Repossessions (Nasdaq: FAKE) currently trade for $75, but the intrinsic value of the shares is $100, then the margin of safety is 25%. On a related note, the potential upside on the shares is 33%.

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