How to Use the Margin of Safety Formula for Value Investing - No BS Investing
Posted 252 views June 17, 2022, 10:00 - Elisabeth in Investing

How to Use the Margin of Safety Formula for Value Investing

“Safety first” when it comes to investing. Applying the margin of safety formula is one way to help you become a safer investor and avoid losing money

Warren Buffett explains margin of safety this way: “The more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need.”

Knowing your margin of safety helps you more safely invest in high-quality companies at bargain prices. Let’s dive more into this formula and how you can calculate and use it as a value investor. 

Key Takeaways:

  • The margin of safety is the percentage difference between the stock price of a company and the actual or intrinsic value of a company. 
  • It helps you determine a safe price to invest in high-quality companies.
  • Margin of safety = 1 – (Current Stock Price) divided by (Intrinsic Stock Price)
  • You want a margin of safety of at least 20%. Warren Buffett says you can apply as much as a 50% discount to the intrinsic value of a stock as a price target.

Note: This article is about the margin of safety formula used by value investors, not the financial ratio used by businesses to determine how much sales can fall before they hit the break-even point.   

What is the margin of safety formula?

The margin of safety formula is a value investing principle. It’s the percentage difference between the stock price of a company and the actual or intrinsic value of a company. This margin of safety calculation helps investors determine a safe price to buy a stock so they don’t lose more money than necessary. The margin of safety formula is:

Margin of safety = 1 – (Current Stock Price) divided by (Intrinsic Stock Price)

You want the stock price (aka current trading price) to be much lower than the intrinsic value of the company so you can buy shares of the company at a discounted price and just in case your intrinsic value calculation is off. 

The margin of safety is used by value investors (aka stock bargain hunters) like Warren Buffett. Value investors look for quality stocks that are undervalued so they can buy at a discount. 

The margin of safety is calculated after you calculate intrinsic value (the company’s earnings, brand, and property). 

Value investors look at a company’s intrinsic value because stock prices reflect investors’ perception of reality, not necessarily reality itself. 

For example, a company’s actual value might be high. But maybe negative news comes out about the company’s leadership. Stock prices could suddenly drop, but that doesn’t mean the company’s actual value did. Value investors buy when the stock price is lower than the intrinsic value of the company. Over the long-term, price will eventually equal absolute or intrinsic value, allowing the investor to sell and make a profit. 

The margin of safety is the level of risk an investor can live with when investing in value companies. If you don’t like much risk, you need a higher margin of safety. Below are the steps to calculate margin of safety. 

Read More: What is Value Investing & How Does it Work?

1. Find the current stock price of the company.

Current stock prices can easily be found through financial sites like Yahoo Finance

But first, here are a few value stocks to choose from. Value stocks are typically from boring companies or companies in a temporary crisis (we never said value investing was sexy but it is profitable!). 

  • Citigroup
  • JPMorgan Chase
  • Bank of America Corporation
  • Berkshire Hathaway
  • Procter & Gamble
  • Johnson & Johnson

To find individual stock prices, head to Yahoo Finance. In the search bar, type in the stock ticker of the company. For example, Johnson & Johnson’s ticker is JNJ. The stock price is featured close to the top of the page:

As of May 17, 2022, JNJ’s stock price was $178.73. Take this approach with any value stocks you’re interested in and write down the current stock price. 

2. Calculate your company’s intrinsic value. 

Several calculations exist to determine a company’s intrinsic value, but we’re focusing on one of the most popular methods; the discounted cash flow (DCF) model. 

This model estimates value based on expected future cash flows. It determines the value of a company today by projecting how much money it will create in the future.

You need several inputs for the calculation. Free cash flow (FCF) is this calculation’s most important input. FCF is the amount of money a company can generate, even after expenses. The DCF model looks at the trailing twelve months FCF and projects it 10 years from now.

Let’s look at Microsoft. According to Microsoft’s cash flow statement (under “Financials” on Yahoo Finance), the company’s trailing twelve months FCF is 60,420,000.

Also, take a look at Microsoft’s cash and cash equivalents. Check the company’s quarterly balance sheet for this information. At the time of writing, Microsoft had cash and cash equivalent value of $16,845,000:

Other inputs for this valuation model include:

  • Total liabilities
  • Growth rates
  • Shares outstanding

Rather than calculating this valuation by hand, you can use a spreadsheet that does the math for you. Download the DCF valuation spreadsheet from valuespreadsheet.com for free here

[Source]

Simply add the ticker symbol and the spreadsheet does the rest, calculating the intrinsic value in the top right corner. 

Again, remember that these numbers are just estimates. In this case, we would need to dig more before determining if Microsoft is a safe buy right now. We could use other intrinsic value models like Return on Equity Valuation Model to compare with these results..

In short, intrinsic value is an educated guess about a company. But an estimate is all you need. According to economist John Maynard Keynes, “It is better to be roughly right than precisely wrong.” 

Read More: How to Calculate the Intrinsic Value of a Company

3. Divide the current stock price by the intrinsic value

With your stock price and intrinsic value calculation in hand, time to apply the margin of safety formula.

Let’s say that XYZ Company has a current stock price of $20. You’ve calculated what you believe to be the intrinsic value of a company: $30. Plug these numbers into the formula:

Margin of safety: 1 – (20/30) = 33%

Your margin of safety percentage is 33%. This means that you’d only purchase the stock if its price was 33% below the intrinsic value. It also means that your intrinsic value calculation could be off by 33% and you still wouldn’t experience any or too much of a loss. 

4. Buy stocks at a price lower than the intrinsic value

When determining what stocks to buy, do the math and ask yourself: am I comfortable with the margin of safety percentage? 

You want a margin of safety of at least 20%. Warren Buffett says you can apply as much as a 50% discount to the intrinsic value of a stock as a price target. It depends on your risk tolerance and how well you know the company. 

Let’s say that the market price of a stock is $15. Its intrinsic value is $10. If your margin of safety is 50%, you’d only buy the stock when the market price is $5 because you’d then have a margin of safety of 50%. 

Margin of safety = 1 – ($15 / $10) = 50%

The higher the margin of safety, the safer your investment. Warren Buffett likens the concept to a bridge. 

Only buy stocks at a massive discount to intrinsic value. This practice gives you a margin of safety and allows you to make money even if your estimate is inaccurate. You might miss some opportunities, but conservatism is the best way to protect yourself from major losses. Better to be safe than sorry. 

Apply the margin of safety formula to buy quality stocks

Remember that margin of safety is only part of the puzzle with value investing. A full fundamental analysis is needed to ensure that you become a successful value investor. Also, you should invest in what you know (e.g., specific industries or companies) to further reduce your risk. 

Did you enjoy this intro to value investing? Learn even more about this strategy when you sign up for the Value Investing Bootcamp: How to Invest Wisely on Udemy. This course helps you learn how to become a successful value investor, step-by-step. Check out the course here

What is margin of safety?

The margin of safety is the difference between a company’s stock price and its intrinsic value. It helps you determine a safe price to invest in high-quality companies. Warren Buffett explains margin of safety this way: “The more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need.”

Why is margin of safety so important?

This calculation helps investors determine a safe price to buy a stock, so they don’t lose more money than necessary. You want the stock price to be significantly lower than intrinsic value, just in case your intrinsic value calculation is off. Aim for a margin of safety of at least 20%. Warren Buffett says you can apply as much as a 50% discount to the intrinsic value of a stock as a price target.

How do you calculate margin of safety?

Margin of safety = 1 – [Current Stock Price] divided by [Intrinsic Stock Price]

What is a good margin of safety in investing?

You want a margin of safety of at least 20%. Warren Buffett says you can apply as much as a 50% discount to the intrinsic value of a stock as a price target. It depends on your risk tolerance and how well you know the company.

What does a 50% margin of safety mean?

With investing, a 50% margin of safety means you will only purchase a stock if the current share price is 50% below your intrinsic value calculation. A margin of safety “cushion” of 50% helps make sure you wouldn’t suffer too much financial loss if your company valuation is off. 

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Elisabeth O. is an MBA graduate with a specialization in International Finance & Investments and over six years of financial writing experience. She is passionate about long-term investing to build wealth, avoids day trading and speculations, and loves a good Warren Buffet quote.