How to Calculate Margin of Safety in Stock Investing

In this article you will find information about what is margin of safety, decide which methods to use and various methods to derive safety margin for each stock.

You will also find information about how safety margin relates to intrinsic value and why 52-weeks historical data is important.

What is Margin of Safety

It was first introduced by Benjamin Graham and David Dodd in 1934. It is basically the difference between the intrinsic value and the stock price. The objective is to determine whether the stock price worth its valuation.

It able to protect stock investors from inaccurate decision making or unexpected downturn in the market. As it is impossible to determine the true value of the company, this safety margin allow investment decision to be made with limited downside.

There are so many methods in determining company’s fair value from margin of safety principle. Here I list the simple ones that are easy and convenient, but as workable as those methods that are complicated. In any case, nobody knows exactly what the company worth for.

How to Determine Margin of Safety

First Method: Discounting the intrinsic value

This is simply discounting the calculated intrinsic value. You can use any discount rate, but 20 to 30 per cent works fine with me.

For example, you find that the intrinsic value for stock GE is $50 and are currently traded at $38. After applying 20 per cent discount, the fair value is $40 (20 per cent discount from $50).

So, current price at $38 is still lower than the discounted intrinsic value. In this case, it is safe for me to buy the stock today.

While Warren Buffet likes to invest in companys that is 50 per cent discounted intrinsic value, Mason Hawkins at Longleaf Partners says his group looks for businesses trading at 60% or less of intrinsic value.

So it is up to you how much you are comfortable with.

Second Method: Comparing with 52-weeks historical prices

To do this, you need to first calculate the difference between 52-week high and low prices, then multiply it with 40 per cent. Then add back to the 52-week low price.



For example, for the last 52-weeks, GE was traded between $32 and $39.5. The difference between 52-week high and low prices is $7.5 ($39.5-$32) and 40 per cent of the difference is $3. Its fair value will be $35 ($32+$3). In this case, as the stock price is still higher than the fair value, it is still not safe to buy it today.
Confused?

Decide Which Methods to Use

How can the first method makes the current price safe to buy but not with the second method?This is not weird. If this happens, it is either:

• you are too optimist with the its EPSGR (result to high future value and high intrinsic value),
• you are expecting very low ROI (result to very high intrinsic value), or
• the stock price is too high from it latest profits announcement etc (more gap between its fair value to current stock price.

The best is, use both and choose whichever is lower. Other than these two methods, I used the third method as well.

It known as sensitivity study. It is not as easy calculation as before, but sort of complementing those two methods.

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