Requiring a Margin of Safety

(7 of 9)

Requiring a Margin of Safety

Although Warren Buffett believes the market is frequently wrong about the fair value of stocks, he doesn’t believe himself to be infallible. If he estimates a company’s fair value at $80 per share, and the company’s stock sells for $77, he will refrain from buying despite the apparent undervaluation. That small discrepancy does not provide an adequate margin of safety, another concept borrowed from Ben Graham. No one can predict cash flows into the distant future with precision, not even for stable businesses with durable competitive advantages. Therefore, any estimate of fair value must include substantial room for error.

To illustrate

For instance, if a stock’s estimated value is $80 per share, then a purchase at $60 allows an investor to be wrong by 25% but still achieve a satisfactory result. The $20 difference between estimated fair value and purchase price is what Graham called the margin of safety. Buffett considers this margin-of-safety principle to be the cornerstone of investment success.