In business and investing, the margin of safety is the amount of buffer that you have above your breakeven target (for a deal) or the intrinsic value of a stock (for investing) to ensure that you don’t lose money. Ensuring that you invest or sign deals only when there is an adequate margin of safety is a common risk management tactic.
Put otherwise, the margin of safety is designed to help handle the situation that one of my suppliers described to me, which he happily shares with new competitors in his industry.
“You know that project you’re planning will deliver half the sales volume, at twice the cost, and in at least double the setup time in your plan, right?”
How To Calculate Margin of Safety (Business)
For a business with specific sales targets and fixed cost amounts, identify the break even point for the business and contribution margin.
Use the contribution margin amount to calculate the breakeven point for the business. For example, if you sell widgets for $5 and earn a $2 contribution margin, you will need to sell 10,000 units to cover $20,000 of fixed costs.
Suppose your projected sales (total sales) for the target profit in your budget are 12,000 units at a price of $5. In that case, your margin of safety would be (12,000 – 10,000) / 12,000 or 16%. Better make sure you hire the right sales leader!
Note that you can calculate margin of safety for budgeting and deal pricing terms two ways: units or dollars. The basic math is the same.
Margin of Safety Example – Deal Pricing
The concept of embedding a margin of safety in your pricing assumptions is particular useful when pricing deals and new products. While we expect total sales for the company to be fairly predictable, individual customers and products frequently miss their budgeted sales targets.
So we must embed a safety factor into the price. This often takes several forms:
- Sales volume assumptions
- Safety margin assumptions, in the event we need to absorb inflation, unexpected cost to serve, or meet a competitor’s price
- Product mix assumptions for multiple product businesses – in the event they purchase plenty of products, just not what we want to be selling them…
Margin of Safety – Investing
For an investor, the margin of safety is the price below the intrinsic value of a security. Intrinsic value buyers use the difference before current market price and their evaluation of the company’s value to create a margin of safety in their investment.
The definition of intrinsic value will be specific to the investor and their comfort level with a business. Here are a couple of ways to value a business, ranked by level of pessimism:
Net Working Capital
Made popular by Benjamin Graham, a value investor, this takes the current assets of a stock (cash and working capital) and subtracts any liabilities. If a stock has positive net working capital, the investor is getting the operating business and fixed investments for free.
Under that level of valuation, you’re pretty much discounting oblivion. You could shut down the business tomorrow and come out ahead.
However, there are three challenges with this approach in the real world:
- Since this financial ratio analysis is mathematical (basic financial statement analysis), most of these opportunities are easily spotted by value investors who will bid up the selling price.
- Since most opportunities are easily spotted, the stocks that don’t increase in price are often burdened with severe operational or corporate governance issues to the point where investors (generally smart people) believe the managers will destroy any value before it can be paid out as dividends. These stocks are known as value traps.
- Stocks that somehow survive both of the above tests (low priced and valuable) often have limitations that prevent other investors from getting interested in the stock. This limits your ability to quickly exit a position.
The third question poses an interesting question: to what degree are you willing to endure pain that keeps other investors out of the picture? If you’re confident in the business and management, it may be worth your while to invest. The stock may be illiquid, the performance erratic… but if you’re truly willing to hold on until the company is sold (or pays out a dividend), this deal might work…
Multiple of Assets or Revenues
Moving upwards on the optimism scale, another common value investing approach is to value the company as a multiple of sales or revenue. While less accurate than a metric such as cash flows, this approach allows you to quickly analyze an underperforming business vs. similar companies.
This isn’t that different than how many strategic acquirers look at the assets of a brand. They know what they can earn on $X on sales revenue in a given industry. They intend to merge the acquired firm onto their operating platform. In the long run, the acquired assets should generate returns competitive with the existing operations, assuming a similar gross margin rate. They can use the results of similar businesses to develop a market price for that block of sales revenue with some profit margin assumptions.
Once they have developed a market price, they embed a healthy discount as a margin of safety percentage.
Future Cash Flows
Normal profitable businesses are valued as a multiple of EBITDA, which is an approximation of their expected future cash flows. This is usually backed by a detailed financial model to map out the size and timing of those cash flow.
Casual value investors look at market price as a multiple of net income, in the form of price earnings ratios. There are various popular formulas for assessing the intrinsic value of a stock based on the price-earnings ratio and expected growth rate. Most of these are basically shorthand for a formal NPV analysis.
Per various books, Warren Buffet’s general concept of margin of safety is aligned with this approach. Most of his investments can be rationalized by NPV Analysis / Cash Flows vs. Ben Graham’s asset based metrics. Investments with a high margin of safety are discounted well below the fair value of their future cash flows.
Future Market Potential
The basis of venture capital investing, this model of value uses the expected future size of the market, the odds of emerging as a market leader, and the expected rewards. While Benjamin Graham might turn up his nose at the lack of analytics, it’s actually not an unreasonable way to look at things.
Consider Google in 1999. The Internet is big and growing quickly, search is a gateway to creating value for most digital businesses, a couple of smart people have a new idea about search. That’s enough for an expected value analysis: really big market x low probability of success.
From there the math involves a lot of hand waving. The usual goal is to start bounding the uncertainty. Is the market for internet search in ten years going to be $30 B or $50 B? Probably unknowable. But we’re comfortable sales dollars for the industry will be north of 10B and less than 100 B. And the leader should have a 50%+ share. What kind of margins could they generate? For that, consult similar industries (media and advertising, the source of their market share) to look at their variable cost economics. It should be close, particularly if they’re replacing an existing activity. And then you need to estimate the odds of Google either winning or being acquired (at a fair value) by the winner of the eventual market shake-out. That’s still a low probability at this stage – but not zero.
Under that logic, if you’re paying $100 MM for the equity, you’re probably high. If you’re investing $1 MM, there’s room. And indeed… it worked out.
Frequently Asked Questions:
Why do we calculate margin of safety?
The concept of analyzing the margin of safety in an investment or commercial operating plan provides a common language for looking at protection against risk. How far do thing have to deteriorate before we’re at risk of a substantial loss. For a creditor’s analysis, this could be interpreted as default on debt obligations.