The margin of safety is a concept used in investment in value that indicates the difference between the intrinsic value of a security and its current price.
The creators of the safety margin concept were Benjamin Graham and David Dodd in 1934. Year in which their first book entitled "Security Analysis" was published. In Spanish, we could translate it as «Security Analysis». Thanks to that book, both authors are considered the parents of value investing. In "Security Analysis" they talked about the principles and techniques that should be applied to analyze financial securities.
The method that Graham and Dodd teach in their publication is about trying to figure out the intrinsic value of a financial security. That is, try to know what the real value is. Once the real value is calculated, it is compared with the market price. When comparing it, an investor must decide whether the security is attractive or not. In other words, if it is cheap or expensive.
The principle of the margin of safety
The idea behind the concept is to offer a rough measure of risk. Value investors clearly differentiate between real or intrinsic value and market price. In this sense, there can be three cases:
- Fairly valued: This occurs when the market price is equal to or very close to the real or intrinsic value.
- Expensive security: A financial security is considered expensive when the market price is higher than its intrinsic value.
- Cheap security: If a financial security is priced below its intrinsic value, it is considered an attractive security.
If a security is fairly valued or expensive, the value investor does nothing. The philosophy of value investing is to buy cheap companies but with potential. In other words, it is not simply about buying cheap. You have to buy cheap and good. Of course, how do we know how cheap a title is. The margin of safety helps us to do this. Graphically it can be represented as follows:
Calculation of the safety margin
Now that we have an intuitive idea of what the margin of safety means, let's learn how it is calculated theoretically. The formula for the margin of safety is:
Safety Margin = [1 - (Market Price / Intrinsic Value)] x 100
As can be seen in the formula, it is a magnitude that is expressed as a percentage. Simply put, it is the discount percentage at which a security is listed. Thus, if the value were 20%, we could say that the security is trading with a 20% discount. Colloquially it is as if it was reduced by 20%.
It should be noted that although it is a very simple calculation, it is very difficult to calculate it. Why? Because the difficulty is that the analysis is good enough to decipher its intrinsic value. Techniques known as business valuation methods are used to calculate intrinsic value. They are methods that include qualitative and quantitative variables.
Example of margin of safety
Imagine a company whose shares are trading at $ 30 each. As followers of the value analysis we are preparing to value the company. That is, to calculate its intrinsic value. To do this, we study the annual accounts for the last financial years using the appropriate company valuation methods. Finally, after a long study, our calculation indicates that the real value of the shares is $ 60. We apply the formula of the safety margin and we obtain that:
Safety margin = [1 - ($ 30 / $ 60)] x 100 = 50%
In other words, the company is trading 50% below its real value. In terms of Graham and Dodd we are going down $ 0.5 for every dollar. This is we have a 50% discount.