How to Calculate Margin of Safety: Definition and Examples
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Summary:
Margin of safety is a calculation used in both business analysis and investing firms to estimate the financial cushion a company has. In investing, the margin of safety refers to a strategy where an investor only purchases a stock or security when it is below the intrinsic value of a company. In business accounting, the margin of safety is the difference between actual sales and the break-even point, the point when a company’s sales will cover its costs.
When investing or running a business, the ability to allocate and manage risk is fundamental to both. One of the most helpful ways to estimate risk is through a company’s margin of safety. Though the margin of safety calculation differs for investors and business owners, the idea remains the same: How much money can I lose before I’m in trouble?
For businesses, the margin of safety is a financial cushion before a company hits its break-even point. Investors, however, use margin of safety to determine the best time to buy a stock or asset. Keep reading to learn how to calculate a business’s margin of safety, how it helps business analysts and investors differently, and why this calculation is vital to a business’s financial health.
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What is the margin of safety?
The margin of safety differs depending on what industry calculates it.
- Investing. A margin of safety acts as a cushion by determining when to buy the stock. This is based on what the investor thinks the true value of the stock or security is (intrinsic value).
- Business analysis. The margin of safety in accounting refers to the cushion between your predicted sales and your break-even point. When the sales of a business cover all of the expenses but no more, this is referred to as the break-even point.
There are multiple margin of safety calculations that allow you to view the margin as a percentage, dollar amount, or number of units. Throughout this article, we’ll primarily view margin of safety in percentage form.
Margin of safety in investing
The margin of safety in investing is a formula that represents the difference between a stock’s present value (market value) versus the stock’s intrinsic value (calculated value).
However, this is also a methodology that some investors use to minimize their risk in purchasing a stock. By purchasing stock at a discount (which is calculated using the margin of safety formula), investors can potentially limit their losses. This method does not guarantee a successful investment but instead attempts to minimize any risk the investor takes on when purchasing a stock.
Example:
Let’s say you see a stock with a share price of $200. When you calculate the stock’s intrinsic value, you estimate that it’s about $175. So you set your discount at 20%, meaning you won’t consider buying the stock until the share price drops to $140.
By only purchasing a stock at a discount to its intrinsic value, you create a margin of safety that could limit your losses should the stock continue to drop in price.
Intrinsic value
When you look at the NASDAQ or S&P 500, those prices represent the market value of a company. The market value is effectively the face value or sales value of a stock or security on a given day. But is this really what the stock is worth?
That’s estimated through a stock or security’s intrinsic value. The estimated intrinsic value of a stock is often calculated through financial modeling that uses the assets, cash flows, and growth prospects of a stock or security.
When calculating intrinsic value, it’s best to consider the following:
- Discounted cash-flow analysis. A discounted cash-flow analysis is a valuation method that uses a company’s expected future cash flows to estimate whether the selling price of a stock is truly fair value.
- Price-to-earnings (P/E) ratio. The P/E ratio is a common way to value a stock or security to determine if it’s selling for a fair price or is undervalued.
- Company assets. Another way to determine a company’s intrinsic value is by determining the value of its assets and subtracting its liabilities. However, this method does not consider any asset growth because many assets on a company’s financial statements are valued at historical cost.
Pro Tip
A stock’s intrinsic value tends to be very subjective. Since there is no absolute calculation, different investors incorporate different values into their calculations. Don’t consider a stock’s intrinsic value as a guarantee it’s a good investment.
How to calculate margin of safety for investments
The margin of safety formula will help determine if an investment fits inside your risk tolerance and valuation philosophy.
If the margin of safety is greater than 20%, the stock is said to have a high margin of safety and thus has less risk than a similar company with a lower margin of safety.
On the other hand, less than 10% would be considered a low margin of safety and would carry higher risk. Generally speaking, value investors look for a margin of safety greater than 20%. However, it is up to the investor to determine at what percentage they purchase the stock.
How does intrinsic value affect this calculation?
The more a company is undervalued based on the analysis of its intrinsic value, the larger margin of safety for the company. In the table below, we take a look at a stock with a share price of $9 per share.
| Share Price | Intrinsic Value | Margin of Safety | |
|---|---|---|---|
| Company A | $9 | $10 | 10.00% |
| Company B | $9 | $11 | 18.18% |
| Company C | $9 | $12 | 25.00% |
You can see that Company A has a margin of safety of 10%, meaning they can afford to be up to 10% off their intrinsic value estimate. Company C has a margin of safety percentage of 25%, meaning that this company can afford to be up to 25% off its intrinsic value target. Based on the safety margin formula, Company C has the highest margin of safety.
Want to know which companies have a high intrinsic value but a low share price? These advisors are the best at finding them.
Margin of safety in business and accounting
Think of a margin of safety as a large fluffy cushion between your projected sales, and the sales needed to break even, or cover your costs. When running a business, you have incoming revenue — typically defined by sales revenue — and outgoing costs, which is everything you spend to run your business.
The break-even point of a business is when the business makes neither a profit nor a loss. Almost any business will want to go through a break-even analysis to reach a number of budgeted sales and actual sales.
Example:
Let’s say you own a business that exports biodegradable plastic. It costs your business $1,000,000 a year to run your business.
This means that you need to reach $1,000,000 in sales a year to cover all of your outgoing costs. At this point, you make neither a profit nor do you lose any money. This means that $1,000,000 is the break-even point. You need to reach $1,000,000 in breakeven sales to break even and not lose money.
How to calculate margin of safety in business
When doing an analysis or conjuring up financial forecasts, it’s important to understand the margin of safety for a business.
Now we can look at the table below to reference what the margin of safety is for this biodegradable plastic exporter. There are three different forecasts for the year based on different sales strategies or a more profitable product mix for the company.
| Current Sales | Break-even Sales | Margin of Safety | |
|---|---|---|---|
| Forecast 1 | $1,000,000 | $1,000,000 | $0 |
| Forecast 2 | $1,200,000 | $1,000,000 | $200,000 |
| Forecast 3 | $1,400,000 | $1,000,000 | $400,000 |
In the first forecast, the company does not have a margin of safety. Since they are earning $1,000,000 in revenue, they are just reaching their break-even point.
In the second and third forecasts, the company has a margin of safety of $200,000 and $400,000, respectively. This allows them to take more risks if needed or account for more variable costs because they have more of a cushion before they reach their break-even point.
FAQs
Is margin of safety the same as profit?
No, a safety margin is not the same as profit. Though both calculations have similar equations, a company’s safety margin and profit highlight different aspects of the company. Where a margin of safety helps determine the risk a company may face, the profit of a business is your earnings.
Why is margin of safety important?
The margin of safety is important when calculating the risk a company may face. What sales volume must be met before you can make a profit? How low does the share price need to drop before you feel good about buying a stock? The higher the margin of safety, the more risk you may take.
Key Takeaways
- The margin of safety is a term used for both investing and business to help measure and allocate risk.
- In investing, the margin of safety is calculated using a stock’s intrinsic value. This value is used to determine if a stock’s true value is above or below the market price.
- The margin of safety in investing is the percentage cushion between the intrinsic value and the current share price.
- Business analysts may use margin of safety to determine how much sales revenue must be taken in to surpass the break-even point.
- The break-even point is when your business’s revenue is high enough to cover all of its costs without making a profit.
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