According to the father of value investing, Benjamin Graham, if you were to distill the secret of sound investment into three words they would be “margin of safety”.
By Graham’s definition, margin of safety refers to the difference between a stock’s price and its intrinsic value; the greater the difference, the more “safety” you have when purchasing said security and vice versa. With this philosophy in mind, we highlight three other ways to think about, and quantify, the concept of margin of safety.
Different Views on Margin of Safety
There’s no clear-cut definition of margin of safety because it all comes down to the individual’s risk preference and investing objectives. As such, it helps to think about this important concept with different perspectives in mind. Here are three different ways to consider thinking about margin of safety when analyzing your next purchase:
- Dividend Yield: You can think of the dividend payment you are receiving as a cushion against any declines in the price of the stock itself; the trick here is to avoid falling for a high-yield dividend trap, which is why it’s best to think of this as the least conservative measure of margin of safety.
- Price Performance: Income investors generally aren’t too focused on price performance, but it may lend worthwhile insights if you consider long-term (at least 3 years) rather than monthly returns. You don’t need to try and time the market, but it is generally prudent to avoid buying a security after a stellar multi-year run-up if you want to have some margin of safety. For patient investors especially, you are better off buying a stock with a solid dividend track record that is trading near its 52-week lows as opposed to its 52-week highs.
- Payout Ratio: This metric is an absolutely critical one to consider when thinking about the margin of safety that a potential investment offers. The payout ratio offers insight into how “safe” a company’s distribution really is; by investing in stocks with more conservative payout ratios (lower is better, but consider industry averages) you have a higher margin of safety that your income stream will be secure even in the event of a business downturn. Learn more about the payout ratio and how to use it.
The Bottom Line
Before pulling the trigger on your next purchase, consider what your margin of safety is; that is, consider the yield, price performance, and payout ratio of a company and compare it to its peers so you have a clearer idea of where a particular stock stands on the margin of safety spectrum.
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