“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger the margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.” Warren Buffett
Billionaire investor Warren Buffett, Chairman and CEO, Berkshire Hathaway, said, “The three most important words in investing are margin of safety.” Margin of Safety is a measure of how “on sale” a company’s stock price is compared to the true value of the company. You need to be able to determine the value of a company and from that value determine a “buy price”. The difference between the two is the margin of safety.
Effectively, margin of safety means you pay less for an asset than what it’s intrinsically worth. It means to buy $10 dollar bills for $5 dollars. That’s the secret to great and successful investing. The margin of safety is the difference between the intrinsic value of a stock and the current market price of the stock. The intrinsic value of an asset is its actual value, that is, the present value of the asset found by calculating the total discounted future income it’s expected to generate.
The intrinsic value is calculated based on the 10 year discounted free cash flow (DFCF).
In other words, if the stock price of a company is below the actual value of the free cash flow (income) and assets of a company, the percentage difference is the Margin of Safety. This is the discounted price at which you are buying a share in the company.
A higher margin of safety will reduce your investment risk. If an investor can buy a stock below its intrinsic value, the potential for a bad outcome, risk, is usually lower.
Warren Buffett likes a margin of safety of over 30%, meaning the stock price could drop by 30%, and he would still not lose money. Margin of safety is only an estimate of a stock’s risk and profit potential.
Buffett determines margin of safety by estimating the current and predicted earnings from a company from today and for the next ten years. He then discounts the cash flow against inflation to get the current value of that cash. This is the Intrinsic Value of the company. He bases intrinsic value on the discounted future free cash flows. He believes cash is a company’s most valuable asset, so he tries to project how much future cash a business will generate.
Margin of Safety is a value investing principle strategy. If the total value of all shares of a company is 30% less than the intrinsic value of that company, then the margin of safety would be 30%. In other words, if the stock price of a company is below the actual value of the cash flow and assets of a company, the percentage difference is the Margin of Safety. This is the discounted price at which you are buying a share in the company. Most value investors believe that the higher the margin of safety, the better. In reality, a margin of safety between 30% and 50% is reasonable.
The Margin of Safety is the percentage difference between a company’s Fair Value per share and its actual stock price. If a company has profits and assets that outweigh a company’s stock market valuation, this represents a Margin of Safety for the investor. The higher the margin of safety, the better.
Margin of safety is only an estimate of a stock’s risk and profit potential. Most value investors believe that the higher the margin of safety, the better. And, the larger the margin of safety, the more irrational the market has become.
One of the keys to getting a great margin of safety is to understand that price and value is not the same thing. Price is what you pay for something, but the value is what you get.
The stock market rises about four out of every five years or about 80% of the time, according to Nick Murray. Said another way, the market only falls 20% of the time. You can fear that 20% or cheer for it.
No one ever got wealthy paying full price or top dollar for financial assets, according to Buffett. Most successful investors got that way buying assets that were distressed, out of favor, and therefore on sale. Unfortunately, few people see it that way. You need to take advantage of the sale during market selloffs and corrections when it occurs. Your money literally goes further because you can buy more share at lower prices that lead to market-beating returns later on.
If you want to make good long-term investment returns, you need to minimize your risk by purchasing companies selling at a significant discount to their intrinsic value due to market volatility.
References:
- https://novelinvestor.com/10-lessons-learned-nick-murray/
- https://www.ruleoneinvesting.com/blog/how-to-invest/how-to-invest-margin-of-safety-the-growth-rate/
- https://www.liberatedstocktrader.com/margin-of-safety/