In investing, it is easy to get into the lure of buying something after it has risen a lot (so that you don’t miss out  in future gains) or buying something after it has fallen a lot (so that you don’t miss the cheap price).

 So, most investors often look at the stock price – what it was a year back, or what it was yesterday – to make a decision whether to buy or avoid a stock.

 But what they forget to consider are two very important things… 

• How does the stock price compare to the company’s “intrinsic value”?
• Is there enough “margin of safety” built into the stock price? 

In this article we focus on the concept of “margin of safety”, which are often considered as the three most important words in investing.

 What is margin of safety?

In simple terms, for stocks, “margin of safety” is the difference between the intrinsic value of a stock and its market price.

 This principle suggests that you must buy a stock only when it is worth more than its price in the market.

 So if a stock is trading at Rs 100 in the market, and you calculate the company’s intrinsic value as Rs 150, you have a margin of safety of Rs 50 (150 minus 100). In other terms, the stock is trading at a 33% discount to the company’s intrinsic value.

If the said stock is of a high quality company, it is advisable to buy it at any price that is 80% or lower than the company’s intrinsic value (any price lower than Rs 120).

And if the said stock is of a company that is not an exceptional one (but worthy enough for investment), you must not buy it for more than 50% of the intrinsic value (only if the price is lower than Rs 75).

Why is margin of safety so important?

Here is what Warren Buffett wrote in his 1963 letters to his investors…

By buying assets at a bargain price, we don’t need to pull any rabbits out of a hat to get extremely good percentage gains. This is the cornerstone of our investment philosophy: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake.”

What Buffett wrote above was like his ode to Ben Graham and his “margin of safety” principle. If you haven’t done it already, read Chapter 20 of Graham’s The Intelligent Investor, where he writes about margin of safety as the central concept of investment.

Buffett calls margin of safety as “the three most important words in all of investing”.

We’re sure they are!