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When contemplating an investment, I might get excited about a company and want to immediately snap up shares of its stock. But I've learned that I should try to determine the value of the company and a fair price for the company's stock before buying. As a general rule, I don't want to pay more for a company than it is worth.
Going further with this idea, I may decide to invest only if I can pay less than the company's value. If I adopt this philosophy, I buy shares of a company only when its price represents a bargain or discount from its value. That is, I incorporate a margin of safety into my investing decisions.
This idea of a “margin of safety” has been articulated and popularized by value investing thought leaders Benjamin Graham, the author of The Intelligent Investor, and Warren Buffett, Graham disciple and billionaire investor.
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.” — Benjamin Graham, The Intelligent Investor
Let's say I think (based on financial analysis) that the fair value of a Widget Company share is $50. If the price is $25, then there is a large margin of safety. If the price is higher, $40 for example, then the margin is small. If the price is $51 or more, there is no margin of safety.
To determine margin of safety, I need to determine a company's value
One of the difficulties in defining the price that represents a safety margin lies in calculating the intrinsic value of a company.
There are many ways to establish value. I have been valuing companies using a cash flow method. Basically, I calculate the present value of future cash flows, which are based on current cash flow and a growth rate I expect considering past performance. Then, I calculate the price per share based on this value.
When I calculate value, I estimate future growth rates. [My assumptions about growth may be wrong; therefore, the value that I assign the company and its share price may be wrong. Generally, I may be too optimistic about a business's potential for growth. However, I could be too pessismistic by underestimating possibilities. Still, I like to apply a consistent, logical way of calculating a fair price.)
After establishing the value, I apply the margin-of-safety principle by telling myself never to pay more than 80% of a stock's estimated value.
Practice safety even when I want to be more aggressive
The biggest problem I have with the margin of safety is that the price of a stock may never fall to the levels indicated for making a purchase. I can be an impatient investor, often fearing that I won't be able to participate in what I anticipate as being significant gains.
However, I have noticed — based on price fluctuations — that adhering to a margin-of-safety policy is wise, particularly if I'm buying a growth stock.
In fact, I've considered using a margin of safety for growth stocks that is greater percentage-wise than more established offerings, such as blue-chip stocks. For example, my margin for a growth stock (representing a relatively new company that seems to be growing rapidly) could be 50% whereas a margin for a blue-chip stock could be 10%.
The reasoning for this approach is that blue-chip companies tend to have more predictable results whereas growth companies are less predictable and harder to value.
Consider safety margin examples from daily life
To get a better perspective on safety in investing, I might think of margins that I deal with daily.
For example, when I ride in a paceline (cycling in a line so that the person in front blocks the wind, enabling those in the back to expend less energy), I may allow extra space between the back wheel of the person ahead of me and my front wheel. This margin-of-safety approach requires me to work harder; but it also allows me to avoid an accident if the person in front makes an unexpected move.
Similarly, suppose I'm an engineer developing the plans for a bridge. I may have specifications indicating the amount of weight that should be supported by the bridge. To that number, I might add a safety margin. I could incorporate building materials or design features to support greater weight than anticipated or required. I'll spend more upfront but be more likely to avert a disaster.
Much of the teachings of Benjamin Graham involve preventing loss. Using a margin of safety in investing decisions may keep me from buying a high-growth stock with potential for above-average returns. But it can prevent investing mistakes, which may allow me to experience greater returns by limiting losses on certain investments.