Lesson 4 of 7
Margin of safety, and what it absorbs
A margin of safety is the gap between the price you pay and the value you estimate. Its size is how wrong your estimate can be before the price was too high.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A margin of safety is the gap between the price you pay and the value you estimate.
- Its size is the error it absorbs: pay 40 percent below your estimate, and the estimate can be 40 percent too high before you paid more than the business was worth.
- The safety comes from the price, not from a better forecast.
Every estimate of value is wrong by some amount you cannot see in advance. A margin of safety is how you plan for that. You do not need a better estimate; you need to pay less than it.
One estimate, two prices
- Your estimate of value$100
- Price A · a 40% margin$60
- Price B · a 10% margin$90
Value if the estimate was 30% too high: $70
Why an estimate needs a margin
Value comes from cash the business will produce for years, and every input to that is a forecast: sales, margins, how much it must reinvest, the rate you discount at. Klarman argues in chapter 8 of Margin of Safety that business value is a range, not a point, and that it moves over time. Graham made the margin of safety the central idea of The Intelligent Investor, in chapter 20: the discount between price and value is what absorbs the error in the estimate.
How big the margin is
Margin of safety equals Estimated value − price divided by Estimated value.
Example($100 − $60) ÷ $100 = 40%
Measure it against your estimate of value, not against the price. A $60 price on a $100 estimate is a 40 percent margin. The rule that follows is simple: a margin of X percent absorbs an estimate that was up to X percent too high. Past that point, you paid more than the business was worth.
A low multiple is not a margin
A low multiple
- Compares one price with other prices.
- Can be low because earnings are about to fall.
- Needs no view of what the business is worth.
A margin of safety
- Compares the price with your own estimate of value.
- Shrinks when the value falls, even if the price does not.
- Is only as good as the estimate under it.
A margin needs a value first. A multiple does not.
Where the margin goes
A margin is not fixed once you buy. It shrinks as the price rises towards your estimate, and it shrinks when the value itself falls: a business losing cash every year is spending the value you measured. Graham's own net current asset (Current assets minus every liability, with factories and property counted at nothing.) test built in a margin of a third, buying at two thirds of that value, and even that margin melts if the company burns through its working capital.
How much is enough
There is no house number. The margin you need is as wide as your error is likely to be. A steady business with a narrow range of outcomes needs less. A cyclical business, a heavily borrowed one, or one you understand less well needs more. The discipline Klarman describes is knowing in advance what you will not pay, and for some businesses no price on offer is low enough.
Check yourself
You estimate a business is worth $100 a share and pay $75. What is your margin of safety?
- 75 percent
- 25 percent
- 33 percent
Show the answer
Answer: B.
($100 − $75) ÷ $100 is 25 percent. The margin is measured against the value, not the price; 33 percent is the gap divided by the price.Your $100 estimate turns out 20 percent too high. What is the most you could have paid without paying more than the business was worth?
- $90
- $80
- $70
Show the answer
Answer: B.
The business was worth $80, so $80 is the ceiling. A 20 percent margin absorbs a 20 percent overestimate and no more.Where does the safety in a margin of safety come from?
- A more detailed forecast
- The price you pay
- A share price that moves less
Show the answer
Answer: B.
Graham and Klarman both put the safety in the price. A detailed forecast can be precisely wrong, and a quiet share price says nothing about the value underneath.Sources
- Graham, The Intelligent Investor, revised edition 1973, chapter 20, on the margin of safety as the central concept of investment.
- Klarman, Margin of Safety, 1991, chapter 8, on business value as a range rather than a point, and throughout on the price as the safety.
- Graham and Dodd, Security Analysis, 1934, on buying below two thirds of net current asset value.
What this leaves out
- Every number here is a round invented input, chosen so the arithmetic can be checked by hand.
- A margin is measured against your own estimate of value. This lesson does not tell you what any business is worth, and a margin built on a wrong estimate protects nothing.
- Nothing here is advice about any security.