Margin of safety

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Margin of safety (safety margin) is the difference between the intrinsic value of a stock (i.e. value based on stock valuation and what the company is actually worth) and the price that the market sets on a stock (i.e. stock price is a matter of market participants' opinions and is different from the intrinsic value).

In Accounting terms, margin of safety is how much output or sales level can fall before a business starts making a loss.

The term "margin of safety" is sometimes used in engineering to describe how overengineered a design is. (see factor of safety)

1 History
2 Application to investing
3 Application to accounting
4 Book
5 See also
6 References

[edit] History

Benjamin Graham and David Dodd, founders of Value Investing, coined the term Margin of Safety their seminal 1934 book, "Security Analysis." The term is also described in Graham's investment classic, "The Intelligent Investor." Graham said that "the margin of safety is always dependent on the price paid" (The Intelligent Investor, Benjamin Graham, HarperBusiness Essentials, 2003).

[edit] Application to investing

Using margin of safety principle, one should buy a stock when its worth is more than its price on the market. This is the central thesis of Value Investing philosophy which espouses preservation of capital as its first rule of investing. Benjamin Graham suggested to look at unpopular or neglected companies with low P/E and P/Book ratios. One should also analyze financial statements and footnotes to understand whether companies have hidden or unobvious assets (i.e. investments in other companies) that are potentially unnoticed by the market.

Warren Buffett, possibly the most famous investor today, was Benjamin Graham's student at Columbia and once said that "the three most important words of investing are 'margin of safety'."

[edit] Application to accounting

In Accounting, margin of safety is the difference between the expected (or actual)sales level and the breakeven sales level. It can be expressed in the equation form as follows:

Margin of Safety = Expected (or) Actual Sales Level (quantity or dollar amount) - Breakeven Sales Level (quantity or dollar amount)

[edit] Book

Also, "Margin of Safety" is a name of a book written by Seth A. Klarman, a successful value investor and President of the Baupost Group, an investment firm based in Boston. This book is no longer published and sometimes can be found on eBay for more than $1000 (some consider it a collectible item).