The ‘margin of safety’ and how investors could use it to find safer bets

If it’s good for an guru like Warren Buffett, it’s probably good for most investors. Here’s the lowdown on the ‘margin of safety’ and how to use it.

Investors might want a larger margin of safety than this. Picture: Getty Images

Warren Buffett is a staunch believer in the concept of the “margin of safety” and has declared it as one of his “cornerstones of investing”.

The world-renown investment guru has said time and time again that the more vulnerable a business is, the larger the margin of safety (MOS) you’d need.

“If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay,” he said.

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“But if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.”

In other words, investors should select a stock only if there is sufficient “room for error”, or when the downside risk is protected.

The MOS is essentially a cushion that allows some losses to be incurred, without losing your shirt in one go.

What is a good margin of safety?

Buffett says he won’t touch a stock unless the MOS is around 30 per cent.

In other words, even if the stock price drops by 30 per cent today, he still wouldn’t lose money if he held on to the stock long term.

Look at it another way, the MOS is the amount of buffer a company has built through its future revenues versus its stock price today.

If today’s stock price undervalues future revenues, then the margin of safety will be higher for the investor.

How MOS is calculated

The MOS is represented as the per cent difference between the current stock price, and the implied fair value per share of the company.

Margin of safety = 1 – (current stock price / intrinsic value per share)

The key to getting an accurate MOS figure is obviously in calculating a company’s intrinsic value.

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There are several ways to calculate this, but we’ll describe two here for brevity:

Discount factor valuation: Buffett prefers this most academic method.

This involves extrapolating the company’s cashflow growth, to, say 10 years forward, and discounting it back to present values.

The key here is obviously is in choosing reasonable growth rates to use.

Predicting a reasonable growth rate is a skill in itself, and involves knowing the fundamentals of the company as well as the wider industry.

But growth can also be assumed from historical rates – i.e. how the company has grown over the past years, or also from the company’s most recent guidance.

Earnings-based valuation: For the rest of us, an easier way to calculate intrinsic value is from data that are already available in the market.

Intrinsic value = EPS (earnings per share) for past 12 months x (1+ growth rate) x P/E (price to earnings) ratio

Here again, a growth rate estimate must also be assumed.

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Some handy examples

Finding a stock with a high enough MOS can be like searching for a needle in a haystack.

But here’s a couple of ASX stocks that could have a margin of safety, although still below Buffett’s benchmark of 30 per cent.

Shoes retailer Accent (ASX:AX1) has an MOS of around 18 per cent.

Accent’s MOS = 1 – (current stock price / intrinsic value per share)

1 – (2.31/2.84) = 18 per cent (assuming a growth rate of 10 per cent).

Peter Warren (ASX:PWR) has an MOS of around 8 per cent.

1 – (2.58/2.79) = 7.6 per cent (assuming a growth rate of 10 per cent).

As always, a single ratio only tells one part of the story for the stock.

Investors are advised to study the company in detail both quantitively and qualitatively.

And don’t be afraid to seek professional advice.

This content first appeared on stockhead.com.au

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