The margin of safety is one of the most important elements of value investing, since it is essential to reduce the risk of our investments and increase their profitability. In this article we will analyze the concept of margin of safety, we will see how it is calculated and the importance of its use in value investing.
What is the margin of safety?
The margin of safety (“margin of safety” in English) is one of the basic tools of value investing to minimize the risk of our financial investments, although, as we will see, it also influences their future profitability. This term was first used by Benjamin Graham in the book "The smart investor”.
We can define the margin of safety as the difference between the price of an asset and its intrinsic value. Therefore, the lower the price of a financial asset, the greater its margin of safety, provided that its intrinsic value does not change.
The intrinsic value is the estimate of the value of a company that we calculate based on its fundamental characteristics such as its annual accounts, competitive advantages or future prospects, while the price of an asset is its market price.
Calculation of the margin of safety with an example
Suppose we want to invest in the company "Academia de Inversión SA", which is listed on the Continuous Market. After analyzing your financial accounts, your business strategy and your prospects for the future, we concluded that your shares have an intrinsic value of € 50 per share. Its shares trade at € 35 per share.
The operations for calculating the safety margin are very simple:
- 50 € – 35€= 15 €
- 15/50 = 30% margin of safety
The importance of investing with a margin of safety
The importance of the safety margin lies mainly in the protection against the risk that can be caused by different events, such as:
- Unexpected events within the company
- Changes in the industrial sector
- Economic crisis
- Analysis and evaluation errors that we make about the company
It is important to note that a high margin of safety does not guarantee 100% not to lose money. Therefore, an additional measure to the safety margin to reduce the risk of our investments is to invest in companies with lasting competitive advantages and stable businesses, which reduce the first 3 risk factors to a minimum. The fourth factor can only be improved by combining theory and practice.
On the other hand, the safety margin not only contributes to risk reduction, but also influences the future profitability of our investments. This is because we buy at a price lower than its value or, as they say, “we buy hard at 4 pesetas”. For example, if we calculate that with an intrinsic value of € 50, the return on the investment will be 9% per year, if we buy with a safety margin of 50% (that is, at € 25) the expected return will be 18 % per year, that is, double.
In summary, when investing it is always advisable, if not essential, to look for companies that have an acceptable margin of safety. It is a matter of common sense that must always be present in intelligent investors.