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Margin of safety: the gap between your fair value and the price

Definition of the margin of safety, its formula, how to estimate a fair value (DCF, multiples), usual thresholds, sensitivity to assumptions and the traps of the exercise.

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Definition

The margin of safety is the gap between your estimate of a share’s value (its fair value) and its price, divided by the fair value. It measures the room left for error: if your estimate is too optimistic, a wide margin keeps the analysis from collapsing entirely. The idea goes back to the work of Benjamin Graham.

Formula

Margin of safety = (fair value − share price) / fair value = 1 − share price / fair value

Where to find it in an annual report

Fair value cannot be read in an annual report: it is your estimate. Its ingredients, however, are there: FCF in the cash flow statement, net debt on the balance sheet, the number of shares in the note on share capital, the outlook in the management report. The share price is today’s.

Common thresholds

Value: 30% or more for green, 15 to 30% for orange. For a very stable and predictable company, some settle for 15 to 20%. For a cyclical or indebted company, whose value is more uncertain, a margin of 40% or more is common.

In the preset strategies

Preset strategy Criterion met To monitor Criterion not met
Value (calculated) Margin of safety (against the fair value entered) ≥ 30% 15% to 30% < 15%

Pitfalls

  • The margin is only as good as the fair value: an estimate that is too optimistic gives a comfortable and misleading margin.
  • A small change in an assumption (discount rate, growth) moves the fair value a lot: test several scenarios.
  • Estimating the fair value after seeing the share price unconsciously pushes you to justify it: make the estimate first.
  • A negative margin means the share price is above your estimate, not necessarily that the share is expensive for everyone.

Where it does not apply

  • Companies with no predictable earnings or FCF (biotech in clinical trials, mining exploration): fair value rests on too many assumptions for a figure to make sense.
  • Banks and insurers: a DCF on FCF does not apply, fair value is rather estimated from equity and the return on it.

A worked example

You estimate the fair value of a fictitious company, called Company M here, at €50 per share. Its share price is €35. The margin of safety is 1 − 35 / 50 = 30%: it reaches green in the Value preset strategy. The margin of safety calculator does the calculation without an account.

Estimating a fair value

There are several methods, none of them exact:

  • Multiples: apply a multiple you consider reasonable to earnings or FCF, for example the historical average of the company or of its sector.
  • DCF (discounted cash flows): estimate the FCF of the coming years, then bring it back to today’s value with a discount rate that reflects the risk. The sum, divided by the number of shares, gives a value per share.
  • Assets: for a company rich in tangible assets, start from book value, adjusted for assets that are overstated or understated.

Why a DCF is sensitive

Take the simplest form of a DCF: FCF of €2 per share, growing by 2% a year forever. The value is 2 × 1.02 / (discount rate − 2%). With an 8% rate, it reaches €34. With a 10% rate, it falls to €25.50. Two points of difference on a single assumption change the value by a quarter. That is the reason for a margin of safety. The simple DCF calculator lets you test these assumptions.

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