- This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income.
- (The margin above charges may be stated in other ways — for example, in the percentage by which revenues or profits may decline before the balance after interest disappears—but the underlying idea remains the same.)
- The bond investor does not expect future average earnings to work out the same as in the past; if he were sure of that, the margin demanded might be small.
- Nor does he rely to any controlling extent on his judgment as to whether future earnings will be materially better or poorer than in the past, if he did that, he would have to measure his margin in terms of a carefully projected income account, instead of emphasizing the margin shown in the past record.
- Here the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.
- If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.
- If the business owes $10 million and is fairly worth $30 million, there is room for a shrinkage of two-thirds in value—at least theoretically—before the bondholders will suffer loss.
- The amount of this extra value, or “cushion,” above the debt may be approximated by using the average market price of the junior stock issues over a period of years.
- Since average stock prices are generally related to average earning power, the margin of “enterprise value” over debt and the margin of earnings over charges will in most cases yield similar results.