Margin of safety
Encyclopedia
Margin of safety is the difference between the intrinsic value
of a stock and its market price..
Another definition: In Break even analysis (accounting), margin of safety is how much output
or sales level can fall before a business reaches its breakeven
point.
and David Dodd
, founders of value investing
, coined the term margin of safety in their seminal 1934 book, Security Analysis. The term is also described in Graham's The Intelligent Investor
. Graham said that "the margin of safety is always dependent on the price paid" (The Intelligent Investor, Benjamin Graham, HarperBusiness Essentials, 2003).
philosophy which espouses preservation of capital as its first rule of investing. Benjamin Graham suggested to look at unpopular or neglected companies with low P/E and P/B ratios. One should also analyze financial statements
and footnotes to understand whether companies have hidden assets (e.g., investments in other companies) that are potentially unnoticed by the market.
The margin of safety protects the investor from both poor decisions and downturns in the market. Because fair value
is difficult to accurately compute, the margin of safety gives the investor room for error.
A common interpretation of margin of safety is how far below intrinsic value one is paying for a stock. For high quality issues, value investors typically want to pay 90 cents for a dollar (90% of intrinsic value) while more speculative stocks should be purchased for up to a 50 percent discount to intrinsic value (pay 50 cents for a dollar).
sales level. It can be expressed in the equation form as follows:
Margin of Safety = Expected (or) Actual Sales Level (quantity or dollar amount) - Breakeven sales Level (quantity or dollar amount)
The measure is especially useful in situations where large portions of a company's sales are at risk, such as when they are tied up in a single customer contract that may be canceled.
written by Seth Klarman
, founder of Baupost Limited Partners, a value investing focused hedge fund based in Boston
, MA. Copies of his book are considered something of a collector's item and it can regularly be found on eBay
or Amazon.com
in the $1200-$2000 price range.
Intrinsic value (finance)
In finance, intrinsic value refers to the value of a security which is intrinsic to or contained in the security itself. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value...
of a stock and its market price..
Another definition: In Break even analysis (accounting), margin of safety is how much output
Output
Output is the term denoting either an exit or changes which exit a system and which activate/modify a process. It is an abstract concept, used in the modeling, system design and system exploitation.-In control theory:...
or sales level can fall before a business reaches its breakeven
Breakeven
In economics & business, specifically cost accounting, the break-even point is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even"...
point.
History
Benjamin GrahamBenjamin Graham
Benjamin Graham was an American economist and professional investor. Graham is considered the first proponent of value investing, an investment approach he began teaching at Columbia Business School in 1928 and subsequently refined with David Dodd through various editions of their famous book...
and David Dodd
David Dodd
David LeFevre Dodd was an American educator, financial analyst, author, economist, professional investor, and in his student years, a of, and as a postgraduate, close colleague of Benjamin Graham at Columbia Business School.The Wall Street Crash of 1929 almost wiped out Graham, who had started...
, founders of value investing
Value investing
Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...
, coined the term margin of safety in their seminal 1934 book, Security Analysis. The term is also described in Graham's The Intelligent Investor
The Intelligent Investor
The Intelligent Investor by Benjamin Graham, first published in 1949, is a widely acclaimed book on value investing, an investment approach Graham began teaching at Columbia Business School in 1928 and subsequently refined with David Dodd...
. Graham said that "the margin of safety is always dependent on the price paid" (The Intelligent Investor, Benjamin Graham, HarperBusiness Essentials, 2003).
Application to investing
Using margin of safety, one should buy a stock when it is worth more than its price on the market. This is the central thesis of value investingValue investing
Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...
philosophy which espouses preservation of capital as its first rule of investing. Benjamin Graham suggested to look at unpopular or neglected companies with low P/E and P/B ratios. One should also analyze financial statements
Financial statements
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
and footnotes to understand whether companies have hidden assets (e.g., investments in other companies) that are potentially unnoticed by the market.
The margin of safety protects the investor from both poor decisions and downturns in the market. Because fair value
Fair value
Fair value, also called fair price , is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as:* acquisition/production/distribution costs, replacement costs,...
is difficult to accurately compute, the margin of safety gives the investor room for error.
A common interpretation of margin of safety is how far below intrinsic value one is paying for a stock. For high quality issues, value investors typically want to pay 90 cents for a dollar (90% of intrinsic value) while more speculative stocks should be purchased for up to a 50 percent discount to intrinsic value (pay 50 cents for a dollar).
Application to accounting
In investing parlance, margin of safety is the difference between the expected (or actual) sales level and the breakevenBreakeven
In economics & business, specifically cost accounting, the break-even point is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even"...
sales level. It can be expressed in the equation form as follows:
Margin of Safety = Expected (or) Actual Sales Level (quantity or dollar amount) - Breakeven sales Level (quantity or dollar amount)
The measure is especially useful in situations where large portions of a company's sales are at risk, such as when they are tied up in a single customer contract that may be canceled.
Rare book
Also, Margin of Safety is a rare and out-of-print bookOut-of-print book
An out-of-print book is a book that is no longer being published. Out-of-print books are often rare, and may be difficult to acquire.A publisher will usually create a print run of a fixed number of copies of a new book. These books can be ordered in bulk by booksellers, and when all the...
written by Seth Klarman
Seth Klarman
Seth Klarman is the founder and president of the Baupost Group, a Boston-based private investment partnership, and the author of a book on value investing.-Career:...
, founder of Baupost Limited Partners, a value investing focused hedge fund based in Boston
Boston
Boston is the capital of and largest city in Massachusetts, and is one of the oldest cities in the United States. The largest city in New England, Boston is regarded as the unofficial "Capital of New England" for its economic and cultural impact on the entire New England region. The city proper had...
, MA. Copies of his book are considered something of a collector's item and it can regularly be found on eBay
EBay
eBay Inc. is an American internet consumer-to-consumer corporation that manages eBay.com, an online auction and shopping website in which people and businesses buy and sell a broad variety of goods and services worldwide...
or Amazon.com
Amazon.com
Amazon.com, Inc. is a multinational electronic commerce company headquartered in Seattle, Washington, United States. It is the world's largest online retailer. Amazon has separate websites for the following countries: United States, Canada, United Kingdom, Germany, France, Italy, Spain, Japan, and...
in the $1200-$2000 price range.