Value Investing and a Margin of Safety

Investing with a margin of safety is a principle conceived of by Benjamin Graham, who is considered by many to be the “father of value investing“. Under this principle, the investor looks to purchase when the actual or “intrinsic” value of the stock is believed to be significantly above the market price. The difference between the two prices is the margin of safety. The idea is that buying with a wide margin of safety minimizes the downside risk associated with the investment.

Benjamin Graham first introduced the concept of investing with a margin of safety in his 1934 book, Security Analysis. He further described the idea in his 1949 work, the Intelligent Investor. This concept has become the cornerstone of value-based investing.

While investing with a margin of safety doesn’t guarantee success, it does provide room for error in the investor’s judgment. Graham acknowledged that when arriving at an intrinsic value, unforeseen and external events may impact the value of the share. As these events cannot be predicted, the investor should build in a margin of safety to allow for such events.

Any given stock will never have a single agreed-upon intrinsic value as there are a number of ways to arrive at this value. Some of the better-known approaches include:

Discounted Cash Flow: Under this valuation method, the analyst discounts the company’s free cash flow projections to arrive at a present value. DCF analysis assigns a value to a company based on the sum of the cash that it could make available to investors in the future.

Gordon Growth Model: Under this model, the intrinsic value of a stock is assigned based on future dividends that are assumed to grow at a constant rate. Because the Gordon Model (very simplistically) assumes a constant growth rate, it is most often used for mature companies.

Benjamin Graham’s Formula: (as described in the “Intelligent Investor”) “Most of the writing of security analysts on formal appraisals relates to the valuation of growth stocks. Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the valuation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations.”

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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