Margin of Safety: why it's Necessary and How to Estimate it
DISCLOSURE: THIS POST MAY CONTAIN AFFILIATE LINKS, MEANING I GET A COMMISSION IF YOU DECIDE TO MAKE A PURCHASE THROUGH MY LINKS, AT NO COST TO YOU. PLEASE READ MY DISCLOSURE FOR MORE INFO.
When buying stocks, how can one be sure you're paying the right price? In fact, the price you pay will play a big part in the level of return you ultimately receive on your investment. Baking in a margin of safety should be a key part of your investment strategy. Before pulling the trigger on any investment opportunity, part of your analysis should be an assessment of the company's intrinsic value versus the current trading price. And then making sure there's a margin of safety included between the price you pay and the upside potential expected on your return.
We’re all human. Since the dawn of time, we’ve been programmed to jump at opportunities. This is especially true when it comes to investing money. When we see a good company, we’re tempted to buy it. If we see others acting on certain investment opportunities, there's an inclination to follow the crowd. Some investors even go the extra mile and crunch the numbers before they do so. But 99% forget about one thing.
When you’re analyzing a potential investment, you’re probably using estimates in a number of respects. We seldom have access to all the data so that’s the only possible way. We have to make some assumptions. But the thing with estimates and assumptions is that they can quickly become misleading. And if you have no safety net, investment decisions can leave you exposed to the turbulence of the financial markets.
Think of a Margin of Safety as a "cushion" put in place to absorb unforeseen risk and/or wrong assumptions. Every year, thousands of investors take heavy losses because they have no cushion. A great checklist is simply not enough. You need more; you need safety. By the way, if you don’t have a checklist, feel free to use mine.
This blueprint is a great start to staying safe. However…
Don't Forget One Crucial Thing
What if your numbers are wrong? There is always a chance that you have made an error, and every mistake comes straight out of your pocket.
That’s why a “margin of safety” is necessary. It is a cushion that protects you as an investor from potential losses due to unforeseen events or changes in market conditions. By using it you will reduce the risk of losing money and increase your chances of realizing a profit. Even the great Warren Buffett has a few words to say on that topic: “The three most important words in investing...Margin of Safety.”
How to Estimate the Margin of Safety
As an investor, you may come across a number of companies as potential investment. Use criteria from my previous posts to hone in on promising investments. Look for well-established companies with a durable competitive advantage and high return on invested capital, among other things. Once optimism about a company's future growth are established through investment analysis, asses the intrinsic value relative to the prevailing price and buy in at a level that includes a nice margin of safety.
Example: Margin of Safety
As an example, let's say a stock being considered is currently trading at $50 per share. Using a discounted cash flow analysis, you determine its intrinsic value to be about $60 per share. The margin of safety in this case would be $10, or the difference between the market price and intrinsic value ($60 - $50). This represents a 20% margin of safety ($10/$50), indicating that the investment has a lower risk of declining in value. To put it more simply, you can be off as much as 20% with your numbers, and you’d still make your desired return. If you’re a visual learner, then the chart below will also aid your understanding.
If you’re wondering how big of a margin of safety you need, I’m afraid I have no real answer for that. The size of the margin of safety is a subjective determination that varies among investors. For conservative investors, a margin of safety of 30% or more is considered desirable, while for more aggressive investors, a margin of safety of 20% or less may be acceptable. In the end, the most important factor is for you to feel comfortable with the level of risk you are exposed to.
For all bargain hunters out there, I have a treat for you. In my next article, I’ll share my view of a popular company. It will be a real eye-opener. Stay tuned. Join my newsletter and get equipped with free tools and knowhow to build wealth and financial security.
Margin of Safety is a tool that should be utilized within investment analysis of any stock. It's a concept that will aid in opportunities being qualified as investments rather than speculation. In many respects, the Market has fashioned investing into speculation. Past performance is a great indicator of future outlook. However, regardless of how excellent the business economics of a company are, you can't lose your sense of proportion about price as an investor. Stocks are not worth any price that an optimistic market quotes.
Selecting stocks in a way that includes a margin of safety will aid in reducing risk and enhancing returns. You can also find ample cushion when the market overreacts to bad news, whether it be temporary, company-specific news or news related to the overall economy. Such instances provide opportunity to leverage a decline in stock prices that provides expanding margins of safety. Look for those opportunities and take advantage great companies selling at attractive prices.
The information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions. I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.