Margin of Safety: Meaning, Formula, and How to Calculate It

What Is Margin of Safety?

Margin of safety in investing means the gap between a price, and what you value the investment at. The idea comes from Benjamin Graham and David Dodd, who wrote Security Analysis in 1934. Graham later made it the centerpiece of The Intelligent Investor. The idea is quite simple. Since nobody can calculate a company's true value, then every valuation is a guess, so we should build a cushion (margin) into the price to mitigate our errors in guessing.

In 1992, Warren Buffett wrote a letter to Berkshire Hathaway shareholders. He mentioned this concept as the foundation of investment success, and that he is not interested in an investment when the value he perceive is only slightly above the price.

"We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying." - Warren Buffett

Margin of Safety Formula

Margin of Safety (%) = (Intrinsic Value − Market Price) ÷ Intrinsic Value × 100

• Intrinsic Value: your own estimate of what the business is worth per share, based on its cash flows, earnings, or assets.

• Market Price: the price the stock is trading at right now.

• Margin of safety: the cushion between the two, shown as a percent of value. A higher percentage means a bigger cushion, while a zero or negative result means no cushion at all.

Two Conventions on Margin of Safety

Let's say, you value a stock at $100, and it costs $80. You can assume the margin relative to the value, or the price. These two ways should always result in the same price gap of $20, so it's just a matter of perspective.

In this article, we use the first one (divided by perceived intrinsic value) because it is the most common form found in value-investing writing. Whenever you compare sources, books, or stock screeners, check which convention they use as the base before comparing numbers.

Maximum Buying Price

Before buying a stock or other securities, you can use the reverse formula to set the highest price you should be buying at.

Maximum Buy Price = Intrinsic Value × (1 − Required Margin)

Using our previous example: if you estimate a stock value at $100, and you require 30% margin, then your ceiling price is $70. This is what investors usually use before placing order.

How to Calculate Margin of Safety

Let's breakdown our example, assuming you value a stock at $100 and the current market price is $80.

1. Estimate intrinsic value: Let's say, you have done some research and decide that this example company is worth about $100 per share.

2. Note the market price: You look at the market, and see that the stock currently trades at $80.

3. Apply the Margin of Safety formula: ($100 − $80) ÷ $100 × 100 = 20%.

4. Compare with the cushion you require. Your personal rule says you want at least 30%.

5. Decide if it passes. 20% is below 30%, so it fails. Your maximum buy price would be $100 × (1 − 0.30) = $70.

Your decision making looks like this:

Margin of Safety Calculator

You can use this calculator to find margin of safety and maximum buy price:

How Do I Put Value on Companies?

Estimating the value of a company is the main job of an investor, and there is no single correct way to do it. These are three of the most common approaches, but nothing can guarantee you accuracy.

Discounted cash flow (DCF): You estimate the cash the business will produce in the future, then shrink those future amounts to what they are worth today. But why do we shrink the future amounts? Because in theory, $1 next year is worth less than $1 now.

For example, let's say, your savings account gives a 2% annual interest rate. This means your $1 will be worth $1.02 next year, and $1 next year is worth $0.98 now. The idea is to not overestimate the future earnings, relative to today's value of your money. This is one of the ways to determine discount rate in DCF method.

Earnings multiples (P/E): If you are looking a stock, and you see that its competitors (similar companies) are all traded at roughly 15 times earnings, you can use this method. If the company you want earns $5 per share, you can multiply it by 15, giving a rough value of $75.

This method is simple and quick, but it only works if the companies you compare with is truly similar in their actual performance.

Asset value (book value): You add up what the company owns and subtract what it owes. This works best for businesses that have mostly physical or financial assets, and it is less effective in estimating companies whose value lies in brands, software, or ideas.

You can start with the company's annual report on Form 10-K, filed with the U.S. Securities and Exchange Commission. It is the primary source for sales, profits, debt, and cash flow, and you can get it for free on the SEC's EDGAR website.

How Big Should Your Margin of Safety Be?

There is no right number, it depends on how predictable the business is. In short: the harder it is for you to forecast, the wider your cushion should be. Benjamin Graham, for example, suggested that he would not buy a stock unless it is priced at two-third its valuation or cheaper. This is historic reference, a not a rule or a recommendation.

If you are looking at a stable company that sells everyday products, earns steady cash, and has little debt, it might be easier to estimate the value, so a smaller cushion may feel reasonable. Oppositely, a company which is yet to make profit, has significant debt, and selling a product completely new to the world, might be harder to estimate and require wider cushion.

Several factors you can consider, among many:

• Earnings stability: have profits been steady or jumpy?

• Debt: heavy debt turns small problems into big ones.

• Competitive position: does the company have an advantage that is hard to copy?

• Your confidence: how well do you really understand the business and trust your inputs?

The less sure you are of your own estimate, the more cushion you need. When the doubt is too high, you may as well look somewhere else.

Limitations: What a Margin of Safety Cannot Protect You From

A margin of safety is meant to lower the cost of mistakes, but it does not remove the possibility of losses. These are four of the main things for you to consider:

• Quality of your data: If your value estimation is too badly wrong, a 30% cushion on a wrong number is still a wrong price.

• Value traps: A stock can be cheap because the business is getting worse, not better.

• Long waits: The price may stay below value for years, and there is no guarantee it ever catches up.

• Missed opportunities: Good companies rarely sell at a big discount, so waiting for a price drop might not work.

Margin of Safety vs. Buying on Margin

Beware of mistaken definition: Buying on margin means borrowing money from your broker to buy securities, and it has nothing to do with a margin of safety. The U.S. SEC's investor site, Investor.gov, defines it that way and explains the risks in its glossary.

Margin of Safety in Accounting

This is another definition you should not mistake. In accounting, margin of safety measures how far a company's sales are above the number of sales it needs just to cover its costs. This is different.

For example: say, a company has sales of $500,000 and break-even sales of $350,000. The (accounting) Margin of safety = $500,000 − $350,000 = $150,000 (30%). Sales could fall 30% before the company starts losing money.