The margin of safety formula provides a way for investors to calculate a safe price at which to buy a security. This method derives from the value investing school of thought.
According to value investing principles, stocks have an intrinsic value and a market value. Intrinsic value is the price they ought to be trading at, while market value is its current price.
Figuring out the difference between these two prices, typically expressed as a percentage, is the essence of the margin of safety formula. Using it correctly can help protect investors from painful losses.
What is a Margin of Safety?
Making profitable investment decisions is largely about investment risk management. The risk involved in a trade needs to be balanced with the potential reward. In financial markets, taking greater risks often gives the potential for greater rewards but also for greater losses–a concept known as the risk-reward ratio.
The best investors find ways to maximize rewards while minimizing risk, shielding themselves from potential losses while being exposed to opportunities for greater-than-average gains.
The purpose of calculating a margin of safety is to give investors a cushion for unexpected losses should their analysis prove to be off. This can be helpful because although estimating the intrinsic value of a stock is supposed to be an objective process, it’s done by humans who can make mistakes or inject their own bias. Even the most experienced and successful traders, both institutional and retail investors–all don’t always make the right call.
To try and correct for this possibility, value investors can determine their margin of safety when entering a position.
Expressed as a percentage, this figure is intended to represent the amount of error that could go into calculating the intrinsic value of a stock without ruining the trade. In other words, the percentage answers the question, “By what margin can I be wrong here without losing too much money?”
Who Uses the Margin of Safety Formula?
The margin of safety is typically used by investors of value stocks. Value investors look for stocks that could be undervalued, or trading at prices lower than they should be, to find profitable trading opportunities. The method for accomplishing this involves the difference between market value and intrinsic value.
The market value of a stock is simply what price it’s trading for at the moment. This fluctuates constantly and can extend well beyond intrinsic value during times of greed or fall far below intrinsic value during times of fear.
Intrinsic value is a calculation of what price a stock likely should be trading at based on fundamental analysis. There are several factors that determine a stock price and the analysis considers both quantitative and qualitative factors. That might include things like past, present, and estimated future earnings, profits and revenue, brand recognition, products and patents owned, or a variety of other factors.
After determining the intrinsic value of a stock, an investor could simply buy it if the current market price happens to be lower. But what if their calculations were wrong? That’s where a margin of safety comes in. Because no one can consider all of the appropriate factors and make a perfect calculation, factoring in a margin of safety can help to ensure investors don’t take unnecessary losses.
The margin of safety formula is also used in accounting to determine how far a company’s sales could fall before the company becomes unprofitable. Here we will focus on the definition used in investing.
How to Calculate Margin of Safety
The margin of safety formula works like this:
Margin of safety = 1 – [Current Stock Price] divided by [Intrinsic Stock Price]
Example Calculating Margin of Safety
Let’s look at a hypothetical case.
An investor wants to buy shares of company A for the current market price of $9 per share. After a thorough analysis of the company’s fundamentals, this investor believes the intrinsic value of the stock to be closer to $10. Plugging these numbers into the margin of safety formula yields the following results:
1 – (9/10) = 10%.
In this example, the margin of safety percentage would be 10%.
The idea is that an investor could be off on their intrinsic value price target by as much as 10% and theoretically not take a loss, or only a very small one.
How to Use Margin of Safety
Now an investor has determined their margin of safety. How might they use this figure?
To provide a substantial cushion for potential losses, an investor could plan to enter into a trade at a price lower than its intrinsic value. This could be done using the calculated margin of safety.
In the example above, say an investor decided that 10% wasn’t a wide enough margin, and instead wanted to be extra cautious and use 20%. They would then set a price target of $8, which is 20% lower than the stock’s estimated value of $10.
In investing, the margin of safety formula is a way for investors to be extra careful when selecting an entry point in a security. By determining a percentage and placing a discount to a stock’s estimated value, an investor can find a mathematical framework with which they can try to be safer with their money.
It’s relatively easy to learn how to calculate one’s margin of safety. There are only two variables – the market value of a stock and the intrinsic value. Dividing the market value by the intrinsic value then subtracting the result from one equals the margin of safety.
But while value investors try to use objective benchmarks for determining when to buy a stock, no analysis can be perfect. Like most calculations that involve figuring out how to value a stock, the margin of safety formula has a large subjective component, even though it’s meant to be rooted in math.
SoFi Invest makes it easy for investors to buy and sell stocks and exchange-traded funds (ETFs). Investors can try to apply the margin of safety formula to their own trades, while learning from educational tools and taking advantage of a user-friendly interface.
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