Margin of Safety - The Three Most Important Words in Investing
According to master investor Warren Buffett, margin of safety are the three most important words in investing.
So what does he mean with a margin of safety and why is it so important? Well, a margin of safety is the difference between the intrinsic value of a company and its current share price.
This difference between value and price functions as a safety buffer, so that even if the company does not perform as well as you expected, you still have a big chance of making money or at the very least protection against major losses.
For example, you calculate that a certain company is worth 10 dollar per share while the stock is currently trading at a price of 5 dollar. This gives you 100% upside potential, or in other words a 100% margin of safety. Now even if the company performs worse than you expected and turns out to be worth only 8 dollar instead of the 10 you calculated, you still have 3 dollar upside potential from your purchase price of 5 dollar!
A margin of safety allows you to make mistakes and still make money. This is important, because it is impossible to predict the future with complete certainty. All you can do is make an educated guess. This is not a problem though, because as Warren Buffett’s business partner Charlie Munger once said: “It is better to be roughly right than precisely wrong”.
So how big should your margin of safety be? Well, let me give you the old cliché: it depends. It depends on how accurate you believe your intrinsic value estimate is, the return on investment you are aiming for, and how vulnerable the business is. You might feel fine driving a 9.500 pounds truck over a bridge made to hold 10.000 pounds when that bridge is just 6 inches above the ground, but you might want a bigger margin of safety when that same bridge is above the Grand Canyon.
I usually aim for a margin of safety between 50 and 100%, because it’s better to be safe than sorry!