Three Words That Matters: Margin of Safety
When I worked as a Trainee at Tata Motors, I got to know about the term payload. In easy words, it is simply the load carried by a vehicle. The payload helps the owner to determine how much they can fit in their vehicle and moreover how many trips they have to take to carry a specific load.
During that time, once I was walking with my manager and we were discussing a light truck – Tata 407, which could carry 2.25 tonnes of payload. And we started talking about its payload. My manager told me that most of the commercial vehicles in India are almost always overloaded and easily crosses the prescribed payload. I asked him why do the Tata trucks perform so well then and why it doesn’t break? Obviously, if you overload the truck with twice its capacity, it should snap. And his answer was Margin of safety!!
Before developing any new vehicle, there’s a comprehensive study done on consumer behavior. And the R&D team of Tata knew this Indian behavior of overloading the truck in order to reduce the total number of trips to carry out the goods. And that’s why the load capacity of the Tata trucks are always more than what specified in the manual.
Moreover, here having a safety is a must for Tata trucks as they are known for their strength and the brand image matters a lot while selling vehicles in the automobile segment. They couldn’t afford to get their brand image ruined by not having a margin on their vehicle’s load capacity.
A similar concept of safety is used in the investing world to reduce the risk and maximize the profit. In fact, it is the central concept of value investing.
What is the Margin of Safety?
The margin of safety means purchasing the stock when the market price of the company is significantly below its intrinsic value. Here, the difference in the intrinsic value and your purchase price is called the Margin of Safety (MOS).
The fundamental analysts believe that there is a true (intrinsic) value for all the company which can be found by reading financials of the company. Moreover, they also believe that the stocks do not trade at their true intrinsic value at most of the time because of speculations and other short term market behavior. A stock can be overvalued or undervalued at any moment of time. And that’s why Investors can make good profits by purchasing stocks when they are trading at a discount i.e. below their true value.
The margin of safety helps to safeguard the investments against calculation error, human error, judgment errors or any other unexpected occurrences concerning the market or stocks.
The margin of safety plays a significant role while purchasing stocks.
For example, if you think a stock is valued at Rs 100 per share (fairly). Then, there is no harm in giving yourself some benefit of the doubt that you may be wrong with your judgment and calculation. And hence, you should buy that stocks at Rs 70 or Rs 80 instead of Rs 100. Here, the difference in the calculated intrinsic amount and your final purchase price is your margin of safety.
The ideal margin of safety depends on the risk tolerance of an investor. The strict value investors may have a MOS of over 50% to minimize the downside risk. On the other hand, aggressive investors may choose a comfortable MOS of 10–15%. As a rule of thumb, always have a margin of safety of between 10–30% on the intrinsic value of the stock while making your investment decisions.
Moreover, apart from the risk tolerance of the investor, this margin of safety percentage also depends on how risky the investment is. If you are investing in a safe blue chip stock, this margin of safety can be comparatively lower than the MOS on high-growth riskier small-cap stocks.
Methods to find Intrinsic value:
The concept of Margin of safety was poularized by the legendary investor, Benjamin Graham (also known as the father of value investing). He used his ‘Graham formula’ to find the true value of companies, and if the stock was trading way below the intrinsic value, only then he would purchase them. This concept of MOS was later inherited by Warren Buffett, a student of Ben Graham.
There are different tools to find the intrinsic value of a company. While many prefer using PE or Book value to find if the stock is undervalued, one of the most popular method to find the true value of a company is the discounted cash flow. DCF analysis is a method of valuing a company using the concepts of the time value of money. Here, all future cash flows of a company are estimated and discounted by using the cost of capital to find their present values. (Read more here: How to value stocks using DCF Analysis?)
A few other methods to find the intrinsic value of a company is the dividend discount model (DDM), EPS valuation, relative valuation etc.
Also check: Intrinsic value calculators
Having a margin of safety in the investments helps the investors to minimize the downside risk. However, an important point to highlight here is that having a MOS does not guarantee that the investment will always be profitable. Finding the intrinsic value of the company correctly also plays a crucial role here. And therefore, you should spend a significant amount of time valuing the stocks suitably.
Nevertheless, a meaningful discount on the purchase price compared to the intrinsic value can limit your losses and maximize the profits on your investments.
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Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting