The accounting, margin-of-safety refers to the difference between the actual sales and break-even sales of a product. This measure is used for the management to understand how much the sales of the company can decrease before the company becomes unprofitable.
In the world of investing, margin-of-safety holds a similar meaning. It is a principle of investing in which margin-of-safety (MOS) implies the difference between the intrinsic value and market price of stock. It is the core concept of investing. According to the principle, an investor should buy a security only when its market price is significantly lower than its intrinsic value.
“All experienced investors recognise that the margin-of-safety concept is essential to the choice of sound bonds and preferred stocks. For example, a railroad should have earned its total fixed charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues. This past ability to earn in excess of interest requirements constitutes the margin-of-safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income.
The bond investor does not expect future average earnings to work out the same as in the past; if he were sure of that, the margin demanded might be small. Here the function of the margin-of-safety is, in essence, that of rendering unnecessary an accurate estimate of the future. If the margin is a large one, then it is enough to assume that future earnings will not fall far below those of the past in order for an investor to feel sufficiently protected against the vicissitudes of time.
There is no surety that the past will be extrapolated into the future. Therefore, even though the bond or a company performed well in the past, there can be no guarantee that the same will continue happening in the near or far future. In this scenario, it becomes necessary for the company to have a back up to fall back on when the future requirements surpass the future earnings.
In the ordinary common stock, bought for investment under normal conditions, the margin-of-safety lies in an expected earning power considerably above the going rate for bonds. Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid. This figure is sufficient to provide a very real margin-of-safety - which, under favourable conditions, will prevent or minimise a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favourable result under “fairly normal conditions” becomes very large.
Thus, the principle of margin-of-safety applies to all forms of securities. Whenever an investor plans to invest in a security, be it bonds or common stock, he must ensure that there is enough margin to cover the adverse situations. This helps the investor to be assured that if something goes wrong in the future, and the past earnings of the company are unable to cover for it, there is still a possibility to avert the losses.
The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. We have here, by definition, a favourable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck. The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments.
There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favour, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses.
margin-of-safety ensures to a large extent that there are more chances of profits than losses. However, this concept needs to be combined with diversification for best outcomes. This is because even if one of the investments goes wrong, even beyond the margin-of-safety, there are other eggs in the basket that can take the impact. The overall outcome of the investment can thus be ensured to be positive. In fact, diversification and margin-of-safety are close companions. Both serve the same basic purpose of averting losses and guaranteeing profits, and complement each other.
As a bottom line, margin-of-safety, combined with adequate diversification, helps the investors achieve their ultimate objective of reducing losses and increasing profits. The investment must, overall, possess the ability to earn in excess of the requirements. This difference provides the safety net to the investors, and is known as the Margin-of-Safety.