The Principle of Margin of Safety in Investment

Key Insight

The margin of safety is central to sound investment, rendering unnecessary precise future estimates by providing protection against unforeseen declines. For bonds and preferred stocks, it is evident when a railroad has earned its total fixed charges better than five times over a period, indicating past ability to exceed interest requirements. Alternatively, for a business owing $10 million and fairly worth $30 million, a two-thirds shrinkage in value is theoretically permissible before bondholders incur loss, with this 'cushion' approximated by the average market price of junior stock issues.

For common stocks, a margin of safety can be as substantial as a good bond's when a company with only common stock is selling under depression conditions for less than the amount of bonds it could safely issue against its assets and earning power, as seen with strongly financed industrial companies in 1932–33, or National Presto Industries in 1972 at a $43 million enterprise value with $16 million in pre-tax earnings. Under normal conditions, common stocks provide a margin when expected earning power significantly exceeds the bond rate, such as a 9% earning power versus a 4% bond rate, creating an average annual margin of 5% that could aggregate to 50% of the price paid over a ten-year period, sufficient to prevent or minimize loss in a diversified portfolio.

However, under 1972 conditions, typical earning power was less than 9%, for instance, an 8.33% earnings return (12 times earnings) for defensive investors, with a 4% dividend yield and 4.33% reinvested, making the excess over bond interest too small for an adequate margin. For growth stocks, the margin relies on carefully estimated future earnings, which must be conservatively made and show a satisfactory margin relative to the price paid, with all estimates erring slightly on the side of understatement; the market often sets prices for favored issues too high to be adequately protected. The margin of safety is always dependent on the price paid, being large at one price and nonexistent at a much higher one, and for undervalued or bargain securities, it is the direct favorable difference between price and appraised value, absorbing miscalculations and adverse developments.