How can you tell if a stock is worth buying now? When the price drops, should you wait for it to fall further, or take advantage of the “discount” right away?
A tool that can help you decide is the “margin of safety.”
What is the margin of safety?
The margin of safety is the difference between what an investment’s is truly worth (or its fair value) and what its currently trading for (known as the market value).
An asset’s current price and its fair value may differ due to factors affecting investor demand.
For example, economic fears, underwhelming earnings, or bad news affecting an entire industry can push a stock's price down even if the underlying business has strong long-term potential.
To estimate fair value, investors can look at things like a company’s earnings, financial health, and growth prospects.
This process can be subjective, such as when valuing an emerging sector with the potential to become more important and valuable in the long run.
Calculating intrinsic value requires assumptions about future earnings, demand, and economic conditions. This is why fair value estimates can vary even among expert investors.
How investors use the margin of safety
Investors set a margin of safety as a guide for making investing moves.
Some follow “value investing,” a strategy that involves buying assets only when they are priced below their intrinsic value.
One way to determine an ideal “discounted” price is by setting a margin of safety you’re comfortable with.
Let’s say you expect a company to grow significantly and believe its stock should be valued at P100 per share.
If you chose to apply a 20% discount as your margin of safety, you’ll wait for the price to drop to P80 or lower before purchasing.
Risk tolerance should play a part in identifying your margin of safety. Conservative investors often apply a larger margin while risk-takers may set a smaller discount.
A larger discount acts as a buffer against miscalculating an asset's worth, reducing the risk of the market price staying below your purchase price.
However, this may require more patience as you wait longer for the price to drop to your desired entry level.
What a margin of safety won't do
A margin of safety doesn’t guarantee protection from loss. It can be difficult to pinpoint the long-term value of an asset due to unpredictable market-moving events.
However, this margin acts as a cushion. The gap between the buying price and perceived value may help prevent a significant investing loss.
