Podcast Transcript

Today we will talk about the Margin of Safety. Basically, the Margin of Safety is the difference between the value of a business, its Intrinsic Value, and the price which you pay for that business, its market price. It is different from the Discount Rate and can vary, depending on the perceived risk of the investment. The Margin of Safety is there to; absorb the impact of any unforeseen events that may adversely affect the business or the market in general, minimise the impact of any miscalculations made during the valuation process, allow for small declines in the company’s future earnings power, as well as taking into account your own risk tolerance. It is imperative not to use the Margin of Safety to justify the purchase of undervalued stocks if their fundamentals aren’t sound.

As a general observation of the market, investors are happy to buy when prices are high, and they see less perceived risk in the market. Then in turn, when the market crashes and prices plummet, they perceive this situation as high risk and sell. Logically, the margin of risk has now greatly reduced as prices are much lower than they were. If you were to purchase quality businesses at this time, your Margin of Safety has greatly increased.

To further increase your Margin of Safety (but not just by purchasing at a lower price) you should stick to businesses that you know and understand. By doing this your evaluations and future earnings predictions will have more meaning and certainty behind them.

To know what Margin of Safety to apply can be difficult. Generally, the riskier the investment the higher the Margin of Safety required. I like to set my desired Margin of Safety after first completing my checklist. I will give each checklist item a rating from 0 to 5, with 5 being excellent, 3 being average, 1 substandard and 0 being non-existent. From here I sum my checklist results to give me an overall rating and then divide that rating by the sum of the total points available. For example, say we have 30 checklist items; each item can achieve a maximum score of 5 points, which would give a total of 150 points (30 checklist items x 5 points for each item). If, after conducting my analysis of the business and giving each checklist item a rating, I arrive at a total of 125 points, I would divide my score of 125 by 150, which equates to 83.3% and by inverting that number I get a Margin of Safety of 16.7%, or 100% – my 83.3% checklist score which equals 16.7%. I will then discount my calculated Intrinsic Value of a company by 16.7% which will equate to my preferred purchase price for that company. For example, if I have calculated the Intrinsic Value of a company to be about $10 per share, I will then discount this price by 16.7% to give me my purchase price for that company, which is now $8.33.

Purchase Price = Intrinsic Value – (Intrinsic Value × Margin of Safety)
= $ 10 – ($10 ×16.7%)
= $ 8.33

As a side note, my minimum required Margin of Safety is set to 20%, so in this circumstance I would use the greater of the two and apply a 20% Margin of Safety, resulting in a lower purchase price of $8.00 instead of the previously stated $8.33.

I believe this approach is a simple and relatively accurate way to assess a company’s risk and thus allowing me to incorporate a Margin of Safety into my Intrinsic Value calculation.

So in summary, we use the Margin of Safety to reduce investment risk. Investment risk includes a few things, first being how much money we could potentially lose after making an investment. If we were to buy the company at its calculated Intrinsic Value, we have to be sure that all our assumptions are correct and that the market acts rationally. If these assumptions are not correct and we have overestimated the profitability of the business, or the market is irrational, then we face the likely possibility of losing money on our investment. So in this instance, if we buy the business at a 20% discount to its Intrinsic Value, this will hopefully reduce the amount of money we could potentially lose. Second, we use the Margin of Safety to account for any unforeseen events that can negatively impact the business, for example a global pandemic. The business may be operating well and meeting its targets, but if an unaccounted for event was to occur, which is out of the control of the business and its management, by applying a Margin of Safety we will reduce the potential loss which may occur due to the unforeseen event. And our third reason to include a Margin of Safety is to account for any errors in judgement in relation to the analysing the business, its earnings and its growth and also to account for any calculation errors we may have made.

Thanks for listening in.

To further express how applying a Margin of Safety works please see the graph below. It is a repeat of the graph above but this time I have included the Purchase Price (Intrinsic Value – Margin of Safety).