The margin of safety is the difference between the intrinsic value of a security and its current market price.
Expanded Definition
Benjamin Graham and David Dodd coined the term "margin of safety" in their 1936 book., Security Analysis. It was also featured in Graham's The Intelligent Investor.
Value investing, which was first described by Graham and Dodd, seeks to buy companies at a discount to their intrinsic value. But a company's intrinsic value, which judges not just the current value of the company but the future value of the company, depends on several variables that can at best be estimated. Therefore, the value investor builds in a margin of safety: the difference between the company's intrinsic value and the market value that would have to exist before the value investor would trust that he or she was truly buying at a discount.
For example, in order to buy a particular security, an investor might require that the market price be 30% below the intrinsic value. This margin of safety would ensure that, even if his calculated intrinsic value were wrong, he would likely not have overpaid.
The margin of safety, in other words, is a way of managing the risk inherent in valuing and buying securities. Investors will often require a smaller margin of safety from an established company with a competitive advantage, for example, than for one in a new and growing industry. As Warren Buffett once quipped, "It is better to be approximately right than precisely wrong."
Example
If shares of Danneskjöld Repossessions (Nasdaq: FAKE) currently trade for $75, but the intrinsic value of the shares is $100, then the margin of safety is 25%. On a related note, the potential upside on the shares is 33%.
http://wiki.fool.com/Margin_of_safety?source=iabsitlnk0000001
Photo: HOWARD McWILLIAM
The property market may be Britain's national obsession but it is proving a hard market to call. Despite fears of a second credit crisis, house prices have recovered to within about 15pc of their peak and the latest figures show that the market is still rising, albeit slowly.
"The market is finely balanced. There are similar numbers of buyers and sellers, and no one can say which way prices will go," said Jeremy Leaf, a north London estate agent. "The market has never been more interesting – in some areas it may be time to sell, in others the right time to buy."
So how can you navigate your way through this jungle? How can sellers pick the right time to put their property on the market, and how can buyers make sure that they pay the right price and don't find themselves saddled with unaffordable debts?
For many, the most important factor in deciding whether now is a good time to buy is the likely direction of house prices. The consensus among economists and housing experts is that the recovery is running out of steam, and that prices look set to stall at best and fall at worst. Such pessimism is fuelled by public sector cuts, further job losses and fears of Britain falling back into recession.
Ed Stansfield of Capital Economics said: "Low interest rates should be supportive for house prices. But public sector job losses, tax rises and spending cuts will squeeze household incomes further, as well as denting confidence.
"What's more, the uncertain outlook for mortgage funding means that the availability of mortgage credit is unlikely to improve and could even be tightened again later this year. Given that the market remains overvalued, I suspect that house prices will end 2010 down by 5pc and will drop a further 10pc in 2011."
Hetal Mehta, the senior economic adviser to the Ernst & Young Item Club, said: "It is not looking good for the housing market ... we may be at a turning point." Howard Archer of IHS Global Insight said he would "not be surprised" if house prices were flat overall for the rest of this year and Peter Bolton King, the head of the National Association of Estate Agents, predicted a similar outcome.
Others predict a sharper correction. After all, as a multiple of earnings, housing remains far more expensive than the long-term average.
According to Nationwide Building Society's house price index, the average first-time buyer now needs 4.4 years' income before tax to buy their first home. Nationwide's average price to earnings ratio since 1983 is just 3.3. By this measure of affordability, prices would have to fall by 28pc from their current level to reach the long-term average for first-time buyers.
Interest rates are also critical, both for their influence on house prices and for the affordability of your own mortgage. A Reuters poll of 61 economists last month found that the majority expected no rise in rates this year, followed by an increase to 0.75pc by the end of the first quarter of 2011 and a further rise to 2pc by the end of the year. Once Bank Rate starts to creep up, history suggests that lenders will swiftly follow suit by increasing mortgage rates.
Ros Altmann, a governor of the London School of Economics, said the small print in the emergency Budget suggested that the Government expected rates to rise too. "The Government's change of pension indexation – pensions will be linked to the Consumer Price Index [CPI] measure of inflation instead of the Retail Price Index [RPI] in order to save costs – confirms that the Government itself expects rates to rise," she said. "CPI will be lower than RPI only if rates go up."
But Mr Stansfield said he expected rates still to be at their current 0.5pc at the end of 2011. "The scale of the fiscal squeeze is likely to ensure that economic growth remains pretty fragile and ensure that the economy continues to operate with ample spare capacity. That will push inflation lower and allow the Bank of England's Monetary Policy Committee to keep interest rates at current levels until at least the end of next year," he said.
For would-be sellers it seems a bigger gamble to hold off in the hope that the housing market will continue to improve than to sell now following a recovery in house prices and an improvement (for the time being) in mortgage lending conditions.
"There has been an increase in the supply of property coming to the market following the abolition of home information packs," said Simon Rubinsohn, the chief economist of the Royal Institution of Chartered Surveyors (RICS). "As a result, the number of new instructions being received by estate agents is now outstripping the increase in buyer interest."
The advice to buyers is to drive a hard bargain. The recovery has not brought the housing market back to the boom days and many sellers will be fearful of a housing slump.
"Some areas have oversupply, others have shortages, although sometimes only of particular types of property," said Mr Leaf, who is also a housing spokesman for the RICS. "To find out what is happening in the area where you want to buy, there is no substitute for doing the legwork. Walk the streets at different times to make sure it is right for you. View plenty of properties, make offers, gauge the reaction – sometimes you find out more from rejections."
There is another reason why now might be the optimum time to dabble in the housing market – mortgage rates are at a seven-year low.
You can avoid a nasty rise in your mortgage repayments when interest rates do rise by choosing a fixed-rate home loan. Although these mortgages tend to be more expensive than variable-rate trackers, you can pay less than 4pc for two-year fixes, while those who want certainty for longer could fix for 10 years at 4.99pc from Yorkshire Building Society, although you would need a 25pc deposit.
There are tentative signs that the mortgage market is worsening and so it might pay to act fast. The Bank of England said on Thursday that mortgages would be harder to obtain in the next three months amid fears of a "deterioration in the economic outlook". It said lenders expected to find it harder to secure the cash on the wholesale markets to fund loans. This was the pivotal reason why mortgages became so costly at the height of the credit crisis.
House price bears reckon that many home owners could not cope with a rise in interest rates. Some, they say, are able to keep their heads above water today only because they are paying rock-bottom interest rates – as low as 2.5pc, in some cases. But these borrowers are fully exposed to a rise in Bank Rate, while remortgaging to a fix will see their repayments rise immediately. A tick up in repossessions cannot be ruled out.
For now, the housing and mortgage markets are in as good health as they have been since the credit crunch took hold, but the outlook looks decidedly grim.
Someone with access to funding who could cope with a rise in interest rates might be able to grab a bargain by choosing the area and property type carefully. Existing home owners whose finances are stretched to the limit might equally take the opportunity provided by the current resilience in prices to get out of the market before prices fall.
