Margin of Safety
Popularized by investing guru Benjamin Graham, the margin of safety concept recommends that investors should only purchase a security when its market price is lower than its intrinsic value. Calculating the intrinsic value of a security is subject to errors because it is based on estimates of the future. When investors incorporate a margin of safety when they decide what they will pay for a stock they reduce the potential negative impact of judgement mistakes.
In order to be a successful investor you need to buy low and sell high. If a stock’s future dividend payouts and free cash flow estimates are too optimistic (resulting in the estimate of a higher intrinsic value for a stock) you may end up paying too much for the stock unless you also include a reasonable margin of safety in determining what you are willing to pay for the stock.
The price you are willing to pay for a stock should be directly related to the value of the company. The higher the risk associated with a stock, the higher the margin of safety you should add. On the other hand, if the company has a history of proven stable profits, a large market share and a very strong competitive position you would might consider paying more for it (with a smaller margin of safety). This is because over time you feel the company will be successful at generating cash and is not as risky an investment.
By using a reasonable margin of safety you are providing a degree of protection from overpaying for a stock. At the same time you will miss out on some buying opportunities but this is a “risk” you should be willing to take to avoid taking some large losses. There are great companies out there but that doesn’t necessarily mean they are great investments if they are over priced and don’t have an adequate margin of safety.