Margin of Safety in Stock Investing

We all have faced situations in life where our decisions have gone wrong. Be it
personal or professional life, our assumptions are proven erroneous and the outcome
is different from what we had anticipated. Stock investing is no different!

We can never be certain that the stock, which we have selected with significant
hard work, would always go up in price. No one can assure us that the company,
which the stock represents, would keep on growing the way it did in the past. All
these elements bring an aspect of risk in investing.

The risk is that the company or the market will prove an investor’s analysis wrong
and instead of generating wealth from the markets, she would end up losing her
hard-earned money. And if not handled diligently, these errors might put her
financial freedom at stake.

One of the all-time best investors, Benjamin Graham, highlighted that no matter how
careful an investor is, she can never eliminate the risk of being wrong. To tackle
this situation Graham introduced the concept of “Margin of Safety” in investing.

Graham presented the Margin of Safety as a tool for minimizing the odds of error in
an investor’s favour. He stressed that Margin of Safety meant never overpaying for
a stock, however attractive the investment opportunity may seem. The Margin of
safety would provide a cushion for unforeseen adverse developments affecting the
investment decision.

Graham in his book “The Intelligent Investor”, first published in 1949, provided a
simple tool for investors to measure the margin of safety in stock investment. He
advised investors to compare earnings yield of a stock to the yield on the bonds
(Government Securities in India) to arrive at the margin of safety.

Simple Steps to assess Margin of Safety in a Stock

A) Margin of Safety in the purchase price:

Earnings Yield being higher than 10 years bond (Government Securities) yield

B) Margin of Safety in the business of the company:

Self Sustainable Growth Rate (SSGR) being higher than current sales growth
Positive Free Cash Flow (FCF) after meeting entire capex