The Margin of Safety is the percentage difference between a company’s Fair Value per share and its actual stock price. This metric is the single most significant valuation metric in our arsenal as it is the final output of detailed discounted cash flow analysis.
The Margin of Safety calculation is relatively easy, the challenge comes in calculating one of the elements of the equation, the Intrinsic Value. Here I provide two examples one for buying a small business and another for calculating the corporate margin of safety that Warren Buffett uses.
The Margin of Safety Formula is:
Margin of Safety = (Intrinsic Value Per Share – Stock Price) / Intrinsic Value Per Share
A Practical Example of the Margin of Safety Formula for Small Business:
If you are interested in buying shares of a company, or even entire business, you will want to estimate the value of the cash it generates into the future. In a very simple way, lets guess that a business you want to buy will generate $10,000 per year for 10 years, after the 10 years the business will be worthless. This means the value of the company might be worth today $100,000 minus the yearly inflation rate for example 2% per year.
This means the value of the income in real terms today is $89,826 (Intrinsic Value)
The business owner wants to sell 100% of the company to you for $60,000 (Stock Price)
Margin of Safety = 33% = ($89,826 – $60,000) / $89,826
Using the Margin of Safety Formula for Corporations & Stocks:
Calculating the intrinsic value of a company and therefore the margin of safety there are many more variables and calculations. For this, you will need to use a Margin of Safety Calculator a simple excel spreadsheet.
Key concepts in calculating the intrinsic value in the excel spreadsheet.
Essentially, Warren Buffett estimates the current and predicted earnings from a company from now for the next 10 years. He then discounts the cash flows against for example inflation, to get the current value of that cash. This is the Intrinsic Value of the business.
Explained another way, Warren Buffett bases his Intrinsic Value calculations on future free cash flows as he believes cash is a company’s most important asset, so he tries to project how much future cash a business will generate.
The usual formula for estimating future Free Cash Flows is the Discounted Cash Flow Method. Here is an example of a simple Discounted Cash flow Method
- Take the free cash flow of the first year and multiply it with the expected growth rate.
- Then calculate the NPV of these cash flows by dividing it by the discount rate.
- Project the cash flows 10 years into the future, and repeat steps one and two for all those years.
- Add up all the NPV’s of the free cash flows.
- Multiply the 10th year with 12 to get the sell-off value.
- Add up the values from steps four, five, and Cash & short-term investments to arrive at the intrinsic value for the entire company.
- Divide this number with the number of shares outstanding to arrive at the intrinsic value per share.
Note: the NPV refers to the Net Present Value or the present value of money. You calculate the Net Present Value by subtracting the discount rate from the future value of the money and multiplying it by the number of years you are measuring.
The advantage of the Discounted Cash Flow Method is that it is simple. The problem with this method is that Free Cash flows can vary dramatically over from year-to-year. Thus, the final figure from this method is guesswork.
The Margin of Safety – What You Should Pay for A Stock
Now that you know what the intrinsic value is per share, you can compare that to the actual share price. If the intrinsic value is more than the actual share price, that would constitute a value investment.
Warren Buffett likes a margin of safety of over 30%, meaning the stock price could drop by 30% and he would still not lose money.
All value investors need to understand that the margin of safety is only an estimate of a stock’s risk and profit potential. There are many risks that fundamental analysis cannot estimate including politics, regulatory actions, technological developments, natural disasters, popular opinion, and market moves.
The margin of safety you use is the level of risk you are comfortable with.
If you are risk-averse, you will want a high margin of safety. A risk-taker, however, could prefer a low margin of safety.