Margin of Safety – MOS
How large should the margin of safety be when considering purchasing a stock?
Benjamin Graham introduced the concept of margin of safety in the financial sector in his book Security Analysis first. In one of his books (The Intelligent Investor), he devotes a whole chapter to this approach.
Briefly explained the Margin of Safety is the difference between the price which the investor is willing to pay and the calculated value of a stock. An investment should only be made with a margin of safety to take care of unexpected developments and errors in assessing the financial health of the company chosen.
However, there is no scientific answer to any exact amount of margin of safety. This depends on various factors, which are ultimately also subjective.
Various considerations to determine the margin of safety
Consider the margin of safety in bonds, the approach is different than with stocks because here it is a key issue that the bonds can be paid back including their interest. Graham explains in Chapter 20 of the Intelligent Investor as follows: So to speak, could the proportion of recoverable assets of a company, etc. which issued the bonds, bank debt exceed the margin of safety view. Or you make sure that the average income of a company significantly exceed the payable interest payments.
As an example the Margin of Safety in a bond is chosen largely to make the investment safe but with limited earnings prospects.
However considering stocks now, the margin of safety is the difference between the calculated value and the price you are willing to pay for a stock. For example, if we calculate the value of a stock at 100 $, and you want to buy it for 60 $, the margin of safety in this case would be 40%.
The larger the margin of safety chosen, the greater the misjudgement of the assessment of the value of a stock may be and the smaller the risk of a permanent loss of capital you will have to take when a less positive development of the investment occurs.
The margin of safety protects an investor but not against possible losses that may arise – long-term chances of profits will be higher than the risk of losses.
Investors often work with a diversified stock portfolio, each stock position selected with a large enough margin of safety, the risk of loss for the entire portfolio with an increasing number of positions is getting smaller.
If investors add positions without or even with negative margin of safety to the “good investments”, then they can not increase the safety of the complete portfolio, but rather reducing it.
How large should the Margin of Safety be?
In order to determine the exact future value of a stock it is necessary to precisely predict the future development of the business of the company. This inevitably has always to do with estimates, whereas there is a reliable way for the past. So does a future prediction contain an estimate, the margin of safety is also an estimate, because this is derived from the future stock price.
If the determination of the value of a stock is conservative, so the margin of safety is rather smaller than if the value of the stock is predicted optimistically. Consequently in an optimistic case the margin of safety is greater. This further also depends on how the value of the company is evaluated. If problems arise in this evaluation, so the Net Current Asset Value may help.
How large the margin of safety should be selected depends on the safety of the forecast and the consequences which arise, if it does not set in.
Forecasts always contain an error potential. So for example it is possible that forecasts do not apply to 100% or the assumption that the company will maintain its market position was not entirely correct.
This condition shows the following: What exact value of margin of safety an investor should select depends on how likely it is that his own forecast does not come true and what the consequences would be for the company’s value.
Subjective component in determining the fair stock price
So it is ultimately less important how exact the company’s value is determined, as it is more important how likely it is, how far the prognosis is from the truth.
To know the limits of one’s own prognosis is more important than the accuracy. So always a subjective component comes into effect when making predictions, which asks at what price the investor feels good to make an investment.
The less known about a company and the more uncertain the future prospects are, the more conservative the determination of the company’s value and margin of safety should be.
To determine the “feel-good price” and the margin of safety some basic numbers will help, such as book value, estimated profitability, Net Current Asset Value or FCF in relation to debt, etc.
How large the margin of safety should be when purchasing a stock depends largely on how the financial situation is assessed and what the uncertainties in determining the company’s value are.
The complex analyses of PURE Rating will support extensively. The Margin of Safety is set standardized to 50% (further explanation can be found here). Further work on analysing a stock may lead to another margin of safety assessment and in this case the following tool will help:
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