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Short Definition

Margin of Safety (potential), or safety margin, is a term produced by Benjamin Graham and used by Warren Buffett to measure the degree of potential for a stock. If the margin is positive, then the stock is undervalue and the investor should buy; otherwise, the investor should sell.

Wiki Wealth uses a margin of safety of 50% to make conservative estimates of the potential of the company. If the margin of safety is above 50%, then an investor should buy the stock.

Margin of safety (safety margin) is the difference between the intrinsic value of a stock and its market price.

Another definition: In Break even analysis (accounting), margin of safety is how much output or sales level can fall before a business reaches its breakeven point.

Long Definition

History

Benjamin Graham and David Dodd, founders of value investing, coined the term margin of safety in their seminal 1934 book, Security Analysis. The term is also described in Graham's The Intelligent Investor. Graham said that "the margin of safety is always dependent on the price paid" (The Intelligent Investor, Benjamin Graham, HarperBusiness Essentials, 2003).

Application to investing

Using margin of safety, one should buy a stock when it is worth more than its price on the market. This is the central thesis of value investing philosophy which espouses preservation of capital as its first rule of investing. Benjamin Graham suggested to look at unpopular or neglected companies with low P/E and P/B ratios. One should also analyze financial statements and footnotes to understand whether companies have hidden assets (e.g., investments in other companies) that are potentially unnoticed by the market.

The margin of safety protects the investor from both poor decisions and downturns in the market. Because fair value is difficult to accurately compute, the margin of safety gives the investor room for error.

A common interpretation of margin of safety is how far below intrinsic value one is paying for a stock. For high quality issues, value investors typically want to pay 90 cents for a dollar (90% of intrinsic value) while more speculative stocks should be purchased for up to a 50 percent discount to intrinsic value (pay 50 cents for a dollar).

See also:

• Fair Value

See Related Analysis

• Buy / Sell / Hold Ratings
• Fair Values
• Potential Returns

• Top Buys
• Top Sells
• Dow Jones
• Warren Buffett

Source: http://en.wikipedia.org/wiki/Margin_of_safety_(financial)