Definition of margin of safety

The difference between the intrinsic value of a stock and the price below which value investors will be willing to make an investment in the given stock. It is a means by which value investors protect their capital and their portfolios from downside risk.

For value investors protecting one's capital is of paramount importance. As a result, and recognising that valuation is subjective and quite uncertain as it deals with the future which is uncertain, value investors will not buy a stock until it has fallen significantly below its intrinsic value.

The estimation of intrinsic value is subject to a lot of subjective judgments, so value investors have borrowed a term from engineering, the margin of safety, to make sure their portfolios have sufficient downside protection.

Originally, Benjamin Graham (financial strategist at Columbia University) talked about a 50 per cent margin of safety; contemporary value investors normally use a 33 per cent margin of safety as the larger the margin of safety, the smaller the probability that one will find truly undervalued stocks. If a stock is valued at $10/share based on the company’s assets and free cash flows, yet is trading at a price of less than $6.66/share, this stock would qualify as a truly undervalued stock and as a value investment. In this case, the stock is trading at a discount to the intrinsic value of more than 33 per cent - that gives an investor room for error. [1]

This term is also used to describe the amount of sales that are in excess of a company’s breakeven point. [2]