Margin of safety (1): the idea
Graham's central idea, the gap between price and value that protects you from error, for bonds, ordinary stocks, growth stocks and bargains, with a calculator.
FinanceGraham ch. 20About 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Define the margin of safety for a bond and for a stock
- Calculate a margin of safety from value and price, and from earnings yield and bond yield
- Explain why the margin depends on the price paid
Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.
The Intelligent Investor: Benjamin Graham's ideas: lesson 22 of 25
- Graham ch. 1
- Investment versus speculation 4 min
- Graham ch. 2
- Inflation and the investor 4 min
- Graham ch. 3
- A century of market history 5 min
- Graham ch. 4
- The defensive investor's portfolio 4 min
- Graham ch. 8
- Mr. Market 5 min
- Living with fluctuations 5 min
- Graham ch. 9
- Investing in funds 5 min
- Costs and the market
- Is advice worth paying for? 7 min
- Reading the accounts
- The balance sheet always balances 5 min
- Graham ch. 5
- Defensive investors and stocks 4 min
- Graham ch. 6
- What the enterprising investor avoids 4 min
- Graham ch. 11
- Security analysis for the lay investor 4 min
- Graham ch. 12
- Per-share earnings and their traps 4 min
- Graham ch. 7
- What the enterprising investor does 5 min
- Graham ch. 13
- Comparing four companies 4 min
- Graham ch. 14
- The defensive investor's screen 4 min
- Graham ch. 15
- The enterprising investor's screen 7 min
- Graham ch. 16
- Convertibles and warrants 6 min
- Graham ch. 17
- Four extreme case histories 7 min
- Graham ch. 18
- Eight pairs of companies 7 min
- Graham ch. 19
- Shareholders, managements and dividends 5 min
- Graham ch. 20
- Margin of safety (1): the idea 5 min
- Margin of safety (2): in practice 7 min
- Graham appendix 1
- The superinvestors of Graham-and-Doddsville 6 min
- Graham postscript
- Graham today 7 min
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Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 20, "'Margin of Safety' as the Central Concept of Investment"
What it is
Asked to sum up sound investment in three words, Graham chose margin of safety. It is the cushion between what you pay and what the investment is reasonably worth, or between what a business earns and what it owes. The cushion absorbs mistakes and bad luck, so you do not need to forecast the future accurately.
For bonds. The margin is the room for earnings or value to fall before the bondholder loses:
- Earnings over interest: Graham's railroad bonds needed fixed charges earned more than 5 times before tax, over a period of years.
- Value over debt: if a business owes 10 million and is fairly worth 30 million, its value could shrink by two-thirds before the bondholders lose.
For ordinary stocks. Here the margin lies in earning power well above the rate on bonds. Graham's figures from earlier editions: earnings of 9% on the price against 4% on bonds gives a margin of 5 points a year. Over ten years that excess can add up to about 50% of the price paid: a real margin of safety. Across a diversified list of twenty or more such stocks, Graham says, a favourable result under fairly normal conditions becomes very probable.
By 1972 he found the margin much thinner: at 12 times earnings, the earnings return is only 8.33%, and he judged the ten-year excess over bond interest too small to be an adequate margin.
Quick check
Tap an answer to check it.
A business owes 20 million and is fairly worth 50 million. By how much could its value fall before the bondholders lose?
- That is the debt as a share of value; the cushion is the rest
- That is the cushion in money; as a share of value it is 30 ÷ 50 = 60%
Show answer
60%. (50 − 20) ÷ 50 = 60%.
Why it matters
The margin depends on the price. Graham's words: it is large at one price, small at a higher one, and non-existent at a higher one still. The same company can be a safe investment or a risky one depending only on what you pay.
Growth stocks. A growth-stock buyer counts on future earnings above the past record. Graham accepts this can give a dependable margin, but only if the estimates are conservative and still show a margin at the price paid. The danger is that the market prices favoured growth stocks above what a conservative projection supports. His rule: any estimate that departs from past performance should err slightly on the side of understatement.
Bargain issues. Here the margin is plainest: the difference between price and appraised value. Even a moderate fall in earning power need not spoil the result. Graham suggests buying undervalued secondary stocks at two-thirds or less of their indicated value.
Where the real losses come from. Not chiefly from paying too much for good stocks, says Graham, but from buying low-quality securities in good times, when investors mistake current good earnings for lasting earning power.
Worked example
You estimate a share is worth 30. It sells at 20, earns 2 a share, and good bonds yield 4%.
- Price as a share of value: 20 ÷ 30 ≈ 67%, so it meets Graham's two-thirds margin.
- Margin of safety: 1 − 20 ÷ 30 ≈ 33%. The value could turn out a third lower than your estimate and the price would still not exceed it.
- Earnings yield: 2 ÷ 20 = 10%. Minus the 4% bond yield: 6 points a year, about 60% of the price over ten years, above Graham's typical 50%.
Try your own figures:
Common mistake
Treating a margin of safety as a guarantee. Graham says the margin gives a better chance of profit than of loss, not certainty: any single holding can still go wrong. That is why he pairs it with diversification (the next lesson).
Key terms
- margin of safety
- the cushion between price and value, or earnings and charges, that absorbs error
- earning power
- what a company can be expected to earn year after year under normal conditions
- earnings yield
- earnings per share ÷ price (the inverse of the P/E)
- enterprise value
- here, the total fair value of a business, against which its debt is compared
- bargain issue
- a security priced well below its appraised value
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| margin of safety | the cushion between price and value, or earnings and charges, that absorbs error |
| earning power | what a company can be expected to earn year after year under normal conditions |
| earnings yield | earnings per share ÷ price (the inverse of the P/E) |
| enterprise value | here, the total fair value of a business, against which its debt is compared |
| bargain issue | a security priced well below its appraised value |
Practice
Work it through
A share sells at 24 and earns 2 a year. Good bonds yield 5%. Your estimate of its value is 32.
- 2 ÷ 24 × 100
- 8.33 − 5
- 3.33 × 10
- 1 − 24 ÷ 32, × 100
Quick quiz
Tap an answer to check it.
In the last exercise, does the price meet Graham's two-thirds standard for bargain issues?
- Graham's bargain standard asks for a price of two-thirds of value or less, a margin of at least a third
Show answer
No: two-thirds of 32 is about 21.33, and the price is 24. A 25% margin is positive but smaller than the third Graham looks for in secondary stocks.
What does Graham say the margin of safety depends on?
- A famous company bought too dear has no margin
- The mood moves the price; the margin is measured from value to price
Show answer
The price paid. Large at one price, small at a higher one, gone at a higher one still.
According to Graham, where do investors' chief losses come from?
- He calls that a real risk, but not the chief hazard
Show answer
Buying low-quality securities in good times. Good current earnings are mistaken for lasting earning power.
In short
- Margin of safety: the cushion between price and value, or earnings and charges, that absorbs error.
- Bonds: earnings well above interest, or value well above debt.
- Stocks: earnings yield well above the bond rate; Graham's typical ten-year excess was about 50% of the price.
- It always depends on the price; growth estimates must be conservative.
- Bargains: price two-thirds of value or less.
Mastery check
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Check yourself
Answer in your head first, then open the answer. Nothing is saved.
In Graham's earlier example, stock earnings of 9% against bond interest of 4% give what margin a year?
Show answer
5 points.
A share is worth 45 by your estimate and sells at 30. What is your margin of safety?
Show answer
About 33% (1 − 30 ÷ 45).
What rule does Graham give for estimates that differ from past performance?
Show answer
They should err at least slightly on the side of understatement.
Further reading
- Benjamin Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 20.
- On this site: Security analysis for the lay investor and What the enterprising investor does.
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