Learn with ETMarkets: What is the margin of safety?

Once you understand what the margin of safety means and how to use it while investing, you can make better investment decisions in your life.

This article will take you through the basics, importance and how you can benefit from margin of safety.

What is the margin of safety?
Benjamin Graham, the father of modern investing, introduced this term.

Investors always wish to buy shares at a lower price than what they are trading at currently. But, when the shares plunge due to uncertain circumstances, they often get scared to buy and speculate what will happen next.

But, when there is uncertainty and the markets have plunged significantly, that’s when the stocks are available at a sale price!

Take the COVID-19 market fall as an example. It was one of the worst ever imagined falls. This market fear made most investors not invest.

However, the COVID-19 market fall was a stock market sale, presenting a golden opportunity to investors. All that was needed was the confidence to invest.

But how do you gather the confidence to invest at such times?

Well, this is where the margin of safety comes into the picture.

The margin of safety is nothing but the principle of buying a share when its share price is significantly below its intrinsic value. This is a strategy that helps you invest at the right time and ensure that the scope of losses is low.

If you carefully analyse Mr. Market, you might have heard the term – ‘The stock is overvalued’ or ‘The stock is undervalued’.

Here you need to learn the art of understanding the value of the business.

How to understand the intrinsic value of a stock?
A variety of factors can determine the intrinsic value of a stock. It is a combination of financial as well as non-financial factors.

Financial factors include operating margins, PE ratio, dividend yield, sales growth, and profit growth.

Non-financial factors include the company’s management quality, economic moat, product competitors, assets, and goodwill.

All of these factors form the intrinsic value of the stock.

What Benjamin Graham has to say about margin of safety?
Graham explains the concept of margin of safety with an example:

Suppose the price of a share is $1. It may happen that the actual value of the same stock might be close to $0.50. So, if you buy it at $1 today, you are adding up unnecessary risk.

Instead, if you buy the share at 50 cents, your chance of losing money substantially decreases compared to buying it at $1 as you buy it at a 50% discount.

You can earn superior returns by purchasing undervalued stocks that eventually realise their true potential over time.

This is why, when you know the true value of a stock and the market dips, you can still find the confidence to buy the share.

Why is margin of safety important?
When you buy undervalued shares, you are protecting yourself from unnecessary losses, along with the possibility that the share price might bounce back when the markets eventually go up.

Hence, by implementing the strategy of margin of safety, you keep the risk at bay while the chances of earning returns are high.

End Note
A higher safety margin below the share’s intrinsic value will protect you from losses. Focusing on the margin of safety encourages you to be a patient investor and buy stocks at the right price.

(The author is Founder, TejiMandi)