The Three Most Important Words Of Investing"Margin Of Safety", probably the most sought-after term in Investment vocabulary of value investors, was best described in a 1991 classic American movie "Other People's Money".
The movie revolves around a "Corporate Raider" who buys companies in trouble & sell their assets to make money. With the help of a software called "Carmen", he identifies a struggling enterprise "New England Wire & Cables" for his latest hunt.
In a meeting with the owners, he offers a hostile bid to buy the stake in the company. In this particular scene which is of roughly 3 minutes, Lawrance, played by Danny De Vitto, uses simple arithmetic & blackboard to describe the intrinsic value of the company, the current price & "Margin Of Safety".
Simply put, the margin of safety is the difference between the intrinsic value of a stock and its market price. The greater the difference the better it is for the investor.
Let's look at an example.
Assume an investor pays INR 900 for a stock he believes to be worth INR 1000.
Because the investor is paying 90% of the estimated inherent value (900 / 1000), his margin of safety is 10%. If the same investor had a chance to buy that stock INR 700 per share, he would have a much greater margin of safety of 30%.
The margin of safety was probably one of the first attempts to overcome the human biases in investing. The concept was simple & its use was helpful in protecting investors from the unknown variables of the stock market. Graham believed that the primary goal of any investor should be his capital protection. The margin of safety not only increases the probability of better returns but also helps in avoiding big losses.
Through examples, Graham reiterated that all experienced investors not only recognized but also used the concept of ‘Margin Of Safety’. For example, while choosing a bond of a company which apparently is a loan, any investor would definitely check whether the company in past has been able to generate at least 4-5 times of the interest payment. Or a bank would never lend to a company who has just enough cash flow which barely services the interest or principle repayment.
Graham used the same concept on stock valuations. He simply ensured that the company has been generating satisfactory cash flow historically & has the strength to generate the same in future too.
The whole concept of Value Investing catapults on the “Price” at which you are acquiring the stock. Because as the legendary Warren Buffet says in the 2008 letter to the Berkshire Hathaway’s shareholders:
Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.