Margin of Safety - Formula, Meaning, ratio, How to Calculate

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Synopsis:

Margin of safety is an investment technique that has been used by all the prominent investors of the world, including Warren Buffet. As per this concept, an investor buys a security only if its intrinsic value is much higher than its market price.

The margin of safety is an investment technique in which an investor buys security only if its intrinsic value is considerably higher than its market price. By ensuring that the intrinsic value (or, real worth) of a security is higher than its market price, investors ensure that they have not paid more than what a security is worth, which allows them a margin of safety. Hence, this concept is termed in this manner. For anyone keen to start trading by opening a demat account, it is important to understand this concept.

Having explained the meaning of margin of safety, let us now understand the concept of ‘intrinsic value’.

What is the Intrinsic Value of an Investment?

The intrinsic value of an investment is its real worth. Investors use a variety of factors to ascertain the intrinsic value, including the quality of a firm’s management and governance; the performance of its industry; and its net profit, assets, and liabilities, etc.

As subjectivity is involved in assessing intrinsic value, multiple investors can arrive at significantly different intrinsic values of a firm. Therefore, if you are beginning to invest, you should be careful while analysing a firm’s intrinsic value. Typically, with experience, investors tend to become better at making such an assessment.

How to Calculate Margin of Safety?

Let us say that a stock called ‘A’ is trading at Rs. 100 a share. As a trader, you are keen to buy it. You estimate that its intrinsic value is Rs. 140 a share. The formula of margin of safety is given below:

Margin of Safety = Intrinsic Value – Market Price

In this case, Rs. 40 (140 minus 100) is the intrinsic value of A. Since the share’s margin of safety is Rs. 40, you can consider investing in it. Now, let us consider another situation. Suppose the intrinsic value of this stock is Rs. 60 and it is trading at Rs. 100, what should you do about it?

You should certainly not buy it because the intrinsic value is much below the price. Now suppose the price falls to Rs. 60, should you then buy it? To be on the safer side, you should still not buy it. Remember that the intrinsic value at best is a subjective estimate.

Therefore, you should wait for the price to fall much below the intrinsic value, and only then should you buy this stock.

How to Calculate Margin of Safety From an Accounting Point of View?

So far we have discussed margin of safety from the viewpoint of making an investment. Now, let us discuss this concept from an accounting viewpoint. In accounting terms, margin of safety is the difference between a company’s actual sales and its break-even sales.

You may wonder what ‘break-even sales’ is. Break-even sales is the amount of sales a business needs to have in order to earn zero profit and zero loss. If a company’s actual sales are higher than its break-even sales, it means it has a margin of safety. Therefore, such a company must be making a profit.

However, if its actual sales are lesser than its break-even sales, it means it does not have margin of safety and such a company must be making losses.

In this case, the margin of safety formula is given below:

Margin of safety = Actual sales – Break-even sales

This formula can also be worked out in the form of a ratio.

Margin of safety ratio = [(Actual Sales – Break-even Sales)/(Actual Sales)]*100

Conclusion

As a concept, margin of safety has been used by acclaimed investors like Warren Buffet and many others worldwide. Therefore, investors should learn how to use it. That said, since there is a degree of subjectivity involved in assessing the intrinsic value of an investment, caution should be exercised while using this concept. This concept can be useful while purchasing stocks or deploying options trading strategies.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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