Warren Buffett is a big believer in Margin of Safety
A margin of safety allows room for error for the investor
So what is it, and how do you calculate it?
Warren Buffett is a staunch believer in the concept of ‘margin of safety’ and has declared it as one of his “cornerstones of investing”.
The Oracle of Omaha has said time and time again that the more vulnerable a business is, the larger the margin of safety (MOS) you’d need.
“If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay.
“But if it’s over the Grand Canyon, you may feel you want a little larger margin of safety,” Buffett said.
In other words, investors should select a stock only if there is sufficient “room for error”, or when the downside risk is protected.
The MOS is essentially a cushion that allows some losses to be incurred, without losing your shirt in one go.
What is a good margin of safety?
Buffett says he won’t touch a stock unless the MOS is around 30%.
In other words, even if the stock price drops by 30% today, he still wouldn’t lose money if he held on to the stock long term.
Look at it another way, the MOS is the amount of buffer a company has built through its future revenues versus its stock price today.
If today’s stock price undervalues future revenues, then the margin of safety will be higher for the investor.
How is MOS calculated?
The MOS is represented as the percent difference between the current stock price, and the implied fair value per share of the company.
Margin of Safety = 1 – (Current Stock Price / Intrinsic Value Per Share)
The key to getting an accurate MOS figure is obviously in calculating a company’s Intrinsic Value.
There are several ways to calculate this, but we’ll describe two here for brevity:
Discount Factor Valuation
Buffett obviously prefers the most academic method, which is the Discount Factor method.
This involves extrapolating the company’s cashflow growth, to, say 10 years forward, and discounting it back to present values.
The key here is obviously is in choosing reasonable growth rates to use.
Predicting a reasonable growth rate is a skill in itself, and involves knowing the fundamentals of the company as well as the wider industry.
But growth can also be assumed from historical rates – i.e. how the company has grown over the past years, or also from the company’s most recent guidance.
Earnings based valuation
For the rest of us, an easier way to calculate Intrinsic Value is from data that are already available in the market.
Intrinsic Value = EPS for last 12 months x (1+ growth rate) x P/E Ratio
Here again, a growth rate estimate must also be assumed.
Examples of ASX stocks with their margin of safety
Obviously finding a stock with a high enough MOS is like a needle in a haystack, and that’s exactly how it should be.
But here’s a couple of ASX stocks that could have a little bit of margin of safety, although still below Buffett’s benchmark of 30%.
Shoes retailer Accent (ASX:AX1) has an MOS of around 18%.
Accent’s MOS = 1 – (Current Stock Price / Intrinsic Value Per Share)
= 1 – (2.31/2.84) = 18% (assuming a growth rate of 10%).
Peter Warren (ASX:PWR) has an MOS of around 8%.
Peter Warren’s MOS = 1 – (Current Stock Price / Intrinsic Value Per Share)
= 1 – (2.58/2.79) = 7.6% (assuming a growth rate of 10%).
As always, a single ratio only tells one part of the story for the stock. Investors are advised to study the company in detail both quantitively and qualitatively.
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