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(Precious) Words of Wisdom : "Wall Street makes its money on ACTIVITY, you make your money on INACTIVITY." ~ Warren Buffett

Warren Buffett’s Margin of Safety Decoded

Equity investing, as we all know, is risky. The idea behind theory of Margin of Safety is to reduce the risk. The principle is actually very simple – buy when the price is low. This automatically reduces the risk of losing money and increases the probability of making profit.

The question, however, is ‘what exactly is low price’?

Before we understand what is low, we must appreciate the fact that every share has a certain “Value”. One must, however, not confuse Value with Price.

  • Price is what the market is willing to pay for the share at any given moment of time. It fluctuates from minute to minute.
  • Value of a share is the value of the underlying business. It is more stable, as fortunes of the business do not change from minute to minute.
People tend to buy low "priced" shares assuming they are cheap. However, many of these have poor business model and hence very low (or even negative) value. So despite being low-priced they are a bad buy as they have NO "Value".

Therefore, never look at Price in isolation. Always compare it with Value.

Are you looking at the PRICE of a stock or is VALUE?

The principle behind Margin of Safety is to buy when the Price is at a discount to Value. If the value of the business works out to Rs.150/share and say the Market Price is Rs.125/share, you are effectively getting something at a discount of Rs.25.

While there is no guarantee that the Price will not go below Rs.125, the probability is low. Sooner or later the market will realize the true value of the business and the chance of the Price moving to Rs.150 and beyond is high. In other words, the risk of losing money is low, while the odds of making money are high.

It stands to logic that higher the discount, the lower is the risk – i.e. there is a higher Margin of Safety.

There’s another way of looking at the concept of Margin of Safety:

Say EPS is Rs.50 and we buy the share for Rs.550. Thus, in one year, we will earn Rs.50 (assuming entire profit is distributed as dividend) on an investment of Rs.550 i.e. a return of about 9% p.a. [simply speaking Return = 1/PE*100].

Vis-à-vis this, suppose we can earn 8-9% risk-free returns in Fixed Deposits. So the Margin of Safety in this case is practically nil [=9% - 8 to 9%]. To reduce the risk, we must have a higher gap. Warren Buffett recommends this gap to be at least 1.25-1.5%.

Valuing a business is a tricky and complicated affair. It requires thorough understanding of the accounts, balance sheet analysis and economic assessment. Therefore, you should ideally leave it to the experts to determine the company's inherent share value.

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