When we value a company we are finding its true intrinsic value, from which we can find the true value of its stock price. We do this because in the long-term (years), stocks will always end up trading at this true inherent value. Stocks may jump up or down in the short-term, but in the long-term it’s well-known that they will always end up at their true inherent value. However, all companies will face short-term issues and this can cause stocks to fall. Further, our calculations may be wrong, so we also want some protection in the event that our calculations are wrong. How do we get protection from these factors? We give ourselves a buffer of safety – this is the margin of safety. So once we calculate the intrinsic value of a company, we will then apply a margin of safety to determine our target price for the stock. If we can buy our stock at our target price which includes this buffer of safety, then we’re essentially buying it at a rock-bottom price. Remember, the risk of losing money is dependent on the price you pay for the stock. If you buy it at a rock-bottom price with a margin of safety, then how much further down could it really go? We’re limiting our downside which will limit our risk of losing money.
So how do we pick the margin of safety? This will be dependent on three factors. The first is the company’s moat. Companies with a moat are much less likely to fall to lowly levels than companies without a moat. We’ve already addressed this in step 1 by investing only in companies with a moat – so we’re good on this front. The second factor will be your own confidence in the company. If you feel very confident about a company, you won’t use as much of a margin of safety. If you can see a company is truly blossoming and will continue to do so, then you won’t use a higher margin of safety (MoS) than when you’re investing a company that you’re less certain about. This confidence in the company will come from your knowledge of the company as a customer or consumer of its products – yet another reason why we want to invest in companies that we know well. The final factor will be how much the company’s stock fell in the GFC. The GFC in 2008-09 was one of the worst financial crises in human history. So looking at how much your company’s stock fell then will give you an indicator of the worst-case scenario for the stock. If it fell by 60% in the GFC, then that is just about as bad as it could get for the stock, so you know that a 60% margin of safety would be an ultra-conservative worst-case scenario to use. For example, I tend to use a 50% MoS for clothing and footwear stocks, as they tend to fall by 50% in a recession.
So when it comes to putting the margin of safety into your calculations, note that the MoS is the amount of buffer you want on the downside. So if you want a 40% downside buffer, then your MoS will be 40%, not 60%. I would suggest that you always use at least a 20% MoS – even if the company is as consistent and robust as say an alcohol company, because you never know what will happen.