Finally, we will discuss an extremely important concept for all long-term investors, which is called Margin of Safety.
Margin of Safety was first referred to by Benjamin Graham in his genius book The Intelligent Investor, which we highly recommend you to buy and read yourself!
All quotes used on this page are taken directly from his book.
The Margin of Safety is a principle in investing that emphasizes purchasing assets at prices significantly below their intrinsic value to reduce risk and protect against errors in valuation. And thus to minimize downside risk while maintaining the potential for high long-term returns.
“To have a true investment, there must be present a true Margin of Safety. And a true Margin of Safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”
More specifically, if a certain companies balance sheet would give it a total value of let’s say $1 billion, you should only but its shares when you can buy them significantly below the total companies value. The major reason for this is that if their shares were to drop for any unexpected reason, your Margin of Safety would be your “safety cushion” and you will not suffer any losses directly!
Margin of Safety can simply be measured by subtracting the price of the stock from the intrinsic value of the underlying business.
By intrinsic value we mean the true economic value of an asset based on the balance sheet, instead of its current market price. Most often the intrinsic value of businesses is calculated by the “discounted cash flow analysis”, which we will discuss in a later blog article.
Warren Buffett is one of the most prominent investors in the world and he has studied the books of Benjamin Graham at a very young age. He was really impressed by Grahams works and has adapted his Margin of Safety principle in his investment philosophy. He always tries to buy high-quality businesses at reasonable prices.
Warren Buffett has always bought assets with a certain Margin of Safety in mind, and his investing results are truly astonishing!
Having a Margin of Safety is what distinguishes an intelligent investor from the crowd!
When the value of the business exceeds the price of the stock, the Margin of Safety is positive. When the price os the stock is higher than the value of the business, the Margin of Safety is negative.
“The Margin of Safety is always dependent on the price paid. It will be large at one price, small at some higher price, and nonexistent at some still higher price.”
“Most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over – and often sooner than that. Nor can the investor count with confidence on an eventual recovery – although this does come about in some proportion of the cases – for he has never had a real safety margin to tide him through adversity”.
We highly recommend you to read The Intelligent Investor yourself!