The concept of the margin of safety, made famous by Benjamin Graham, the father of value investing, is that you should leave a buffer between your purchase price of an assets and the intrinsic value you calculate for that asset. Graham believed in knocking off 1/3 of the value. He borrowed the concept of the margin of safety from the engineering field, where a 10,000 pound capacity bridge may really be designed to carry 15,000 pounds. Image © iStockphoto/Thinkstock

The single most important concept in all of investing, according to Benjamin Graham and later confirmed by his star student, Warren Buffett, comes down to three simple words: Margin of Safety.

What is the margin of safety?  How do you calculate it?  How important is it to developing a successful value investing strategy?  As youll see in a moment, the ultimate return you earn on your investments will likely be closely related to the size and quality of the margin of safety you build in to your purchasing decisions, whether you are buying shares of Coca-Cola or building a hotel.  By understanding the concept and, just as importantly, the reason great value investing practitioners have treated it as holy scripture throughout their career, you can better position yourself to utilize the strategy in your own day-to-day money management activities.

Value Investing Margin of Safety Defined

Benjamin Graham basically described the margin of safety for any asset to be the discount between your carefully and conservatively calculated true value of the business (often called intrinsic value of a company or assets) and the price you paid for that asset.  In other words, if you calculate that a building, company, or timber rights, for example, are worth $1,000,000 and you pay $600,000, your margin of safety is $400,000 ($1,000,000 intrinsic value $600,000 purchase price = $400,000).

Graham borrowed the margin of safety concept for his value investing strategy from the engineering field.  He pointed out that if a bridge says it can handle a load of 10,000 lbs. it will have actually been constructed to handle, say, 15,000 lbs. or more.  This difference of 5,000 is the margin of safety to ensure that the bridge doesnt collapse and kill someone if a stupid, inpatient driver decides to take a risk and drive his 10,200 lbs. truck onto the structure.  The bigger the margin of safety, the less risk involved for the truck driver, the city or county, and those standing by or who happen to be parked on the bridge or coming from the opposite direction.

Calculating Intrinsic Value of a Stock to Estimate the Margin of Safety

How would one go about calculating the estimated private market value or intrinsic value of an assets?  After all, without this knowledge, its impossible to calculate the margin of safety and value investing would be nothing more than speculation under the guise of academic guesswork.  There are several ways:

• Compare the book value of a company to the current share price.  In some cases, the bigger the discount, the more substantial the margin of safety. Book value isnt intrinsic value so you need to estimate how real you think each dollar of book value is.  For instance, if a poorly managed company had acquired only a single asset, say a hotel for which it paid $30 million that has fallen apart and has no chance of ever earning at least $3 million a year (a 10% capitalization rate), you would need to look very skeptically at the balance sheet book value estimate.  You wouldnt want to pay $30 million for the entire company because it the book value, or net worth, of the firm isnt really $30 million.  On the other hand, a company like Berkshire Hathaway has a book value that far understates the intrinsic value assigned by most value investing money managers because only a fraction of the companys earnings power is visible on the income statement due to accounting rules.  In this case, buying Berkshire Hathaway at a discount to book value would represent a substantial margin of safety.

• Look at the buyout multiples for comparable deals.  The smaller the multiple for a particular stock relative to its industry, the larger the margin of safety if the balance sheet is strong. If you have access to a Bloomberg terminal or other research service, look at the average multiple between the buyout price and the companys earnings before interest and taxes (EBIT).  Of course, if you believe the market is in a bubble, this information may not be reliable.  In most markets, however, it is extremely useful because it shows you what real people are willing to pay for a business.  You should prefer financial buyers such as hedge funds because they dont have any synergies from their core businesses, meaning they have the most conservative valuations relative to strategic buyers, which can wring out cost savings.  If most candy companies have been sold at multiples of 10x EBIT and you find a great candy business selling at 6x EBIT, your margin of safety is 4x EBIT.  Thats substantial and, at that level, almost any value investing firm would pick up shares for their account if the balance sheet was strong without a lot of debt.

• Compare the dividend yield to the coupon rate of long-term United States Treasury bonds.  The bigger the difference in favor of the dividend, the larger the margin of safety. If a stock has a dividend payout ratio that is relatively low (say, under 50%), it is well protected and has little or no danger of becoming unsustainable, and the dividend offers a yield far higher than that of the 30-year United States Treasury bond, the stock may offer a huge margin of safety.  This is another type of stock that a lot of value investing firms would pick up for their account fairly quickly.

• The more diversified a companys revenue sources and assets, the bigger the margin of safety. Speaking of Berkshire Hathaways considerable energy holdings, Warren Buffett once remarked that there is often a larger margin of safety investing in a power company with plants spread across several states with a BB credit rating than it is buying shares of a power plant rated AAA yet operating from a single location, such as the company that serviced New Orleans before Katrina.  The margin of safety concept is supposed to be your protection.  No matter how strong the balance sheet, if all of the earning power originated from a single plant that could be taken under by a Category 5 hurricane, you have a very small margin of safety.  You would only want to risk a fraction of your capital no more than 3% at most and buy when the shares were undervalued according to some of the other metrics weve discussed here and in signs of a good value investing stock .

The Margin of Safety Is Your Protection Against Black Swans and Over Confidence