Warren Buffett once said that we should invest only when the price provides us with a margin of safety. But what does a margin of safety really mean? Let’s break it down.

Accounting for shortfalls in forecasts

Investing is a game of probability. 

It is impossible to forecast the exact cash flows and dividends that a company will pay in the future. This is where the concept of a margin of safety comes in. Morgan Housel once wrote:

“Margin of safety is simply the distance between your predictions coming true and needing those predictions to come true. You can still try to predict the future, but a margin of safety gives you room for error to be wrong.”

For instance, we may forecast a company to provide us with $1 per share in dividends for 10 years and then close down after the 10 years is over. 

Using a dividend discount model and a 10% required rate of return, we can calculate that the value of the shares should be $6.14 each. In other words, if we pay $6.14, it will give us a 10% annual return based on the expected dividends we can receive over time.

But what if our forecast falls short? Say the company ends up paying a dividend of only $0.80 per share each year. In this case, paying $6.14 for the company’s shares will not get us our desired return of 10% per year.

To account for this potential 20% shortfall in dividends per share, we should have a margin of safety. We can calculate that we should only buy the stock if the stock price is $4.92 so that we have a “margin of safety” in case our forecast falls short.

Accounting for different discount rates

But a margin of safety does not only mean that we should account for the company’s actual results deviating from our forecasts. There is another crucial factor that comes into play.

If you intend to sell the stock, we need to factor in our sale price, which will be dependent on the buyer’s required rate of return, or discount rate.

For instance, we want to buy the same company above but instead of buying and holding for the full 10 years, we intend to sell the shares after just 5 years.

If we are buying the stock for the full 10 years, we can pay $6.14 per share, knowing that we will get a 10% return simply by collecting the dividend and reinvesting the dividend at a 10% rate.

But if we intend to sell the shares after 5 years, another factor comes into play – the sale price of the shares at the 5-year mark. Obviously, if we can’t get a good price during the sale, our returns will be subpar.

If the person buying the stock from us at the 5-year mark also requires a 10% rate of return, we can sell the stock at “his price” ($3.79) and still receive a 10% annualised return.

However, if the person that we are selling the stock to requires a 12% rate of return, he will only be willing to pay us $3.60 for the shares. In this case, we will receive less than a 10% annual return over our 5-year holding period.

So instead of paying $6.14 per share, we should only pay $5.82 per share to provide us with a margin of safety in case the required rate of return of the buyer goes up to 12% at our point of sale.

Margin for upside

Factoring in a margin of safety provides us comfort that we can achieve our desired rate of return. In addition, if things go smoothly, there is the potential to earn even more than our required rate of return.

But while the concept seems straightforward, its application is a bit more challenging. It requires a keen understanding of business and a valuation that provides sufficient margin of safety. 

It also requires some judgement on our part. How much of a margin of safety is enough? For companies with very stable and predictable dividend streams, our margin of safety can be narrower. But for companies with less predictable dividend streams, we may want to factor in a larger margin of safety.

I also prefer to demand a relatively high rate of return so that it is unlikely that the required rate of return by the buyer at the point of sale will negatively impact my return.

Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.

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Disclosure: Jeremy Chia does not have an interest in any of the companies mentioned.