Tools / Margin of safety
Margin of safetyHow big is the cushion?
Your estimate of value will be wrong by some amount. The margin of safety is the gap between that estimate and the price you pay, and it is what protects you when you are wrong.
Price against value
How this works
Margin of safety = 1 − price ÷ value. If you think a share is worth $100 and it sells for $70, your margin is 30%. If it sells for $110, you have no margin at all; you are paying for more than you think you are getting.
How much to demand depends on how sure you are. A steady business you understand well might justify 20 to 25%. Something cyclical, indebted or hard to forecast deserves more, because the estimate itself is shakier.
The cushion works in two ways. It lowers the damage when your value estimate is too high, and it raises the return when your estimate is right, since the price has further to climb.