Margin of Safety is one of the most important lessons from the investments legend Benjamin Graham.
In simple terms we could say that it is a quick and simple way of determining what is the risk of a potential investment.
To find the Margin of Safety we need to first find the equity of the business and then see how far it is from the listed market price.
The greater the gap between the market price and the equity, the riskier the investment is.
How to find the equity?
The equity also known as book value is the result of subtracting all the liabilities, from all the assets. In other words, if we were to liquidate the business right now!, what would it be worth?
The companies balance sheet is the place we can go to find information about assets and liabilities.
Example
Let's say a business is for sale at a price of 50,000£
When we go to it's balance sheet we see this:
Assets
Cash on account 5,000£
Property 15,000£
Equipment 10,000£
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Total: 30,000£
Liabilities
Owned to employees 10,000£
Owned to suppliers 7,000£
Property(Left to pay) 9,000£
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Total: 26,000£
Equity = 30,000£ - 26,000£ = 4,000£
In the above example we found that the equity is 4,000£ but the business is for sale at 50,000£, so in the example the equity is just 8% of the equity. This seems to be quite a big gap. As a value investor, this would not be considered a good investment.
What is then a good margin of safety?
For some speculators an equity of 50% of the price would be considered a good.
But for value investors a good investment would be if the equity is at higher than the price.
The famous value investor Warren Buffet will invest only if those business where the margin of safety is at least 15 times the market price. So for our example this would mean 1500%