Margin of Safety
One of the first lessons you’re learn in The Intelligent Investor by Benjamin Graham is to seek a “Margin of Safety”. A margin of safety is a disconnect between what you calculate the instrinsical value of the stock to be versus what you can pay for it. The less sure you are about factors the greater margin of safety you should seek in your investment.
The intrinsic value of a share
An investor may calculate the intrinsic value of a share by differing methods and will eventually come up with a price that he or she believes represents good buying value. There are many methods for calculating intrinsic value of varying corporations but having a margin of safety involves having an extra cushion beyond that.
You may be wrong, or there may be external events that affect the value of the shares in your investing or a “black swan event” that no one can see.
Prime bonds vs government bonds
In the Intelligent Investor, the benchmark for calculation of margin of safety was the interest rate payable for a AA Grade quality Corporate bond.
If the risk in two forms of investment is the same, then it must be better to take the investment with the higher return. Conversely, an investment with higher risk, such as shares, should, when calculating the margin of safety, have a higher return.
Part of the investment process and margin of safety is making sure there is being offered enough upside for the risk being assumed.
Company A is earnings $10 per share and is selling the market for $200. If the rate of return on a government bond like it is now 2.75%.
Company A is yielding 5% and has a Price to Earnings Ratio of 20, versus the government bond which is yielding 2.75%
All things being equal in risk you would choose Company A.
Total margin of safety will fluctuate depending upon the quality of the share investment.
…a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience. -Benjamin Graham, The Intelligent Investor
InvestCorrectly Learning How to Invest Series