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Margin of Safety
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We've analyzed a company, we've valued it—now we need to know when to buy it. If you really want to succeed as an investor, you should seek to buy companies at a discount to your estimate of their intrinsic value. Any valua­tion and any analysis is subject to error, and we can minimize the effect of these errors by buying stocks only at a significant discount to our estimated intrinsic value. This discount is called the margin of safety, a term first popularized by investing great Benjamin Graham.

Here's how it works. Let's say we think Clorox is worth $54, and the stock is trading at $45. If we buy the stock and we're exactly right about our analysis, the return we receive should be the difference between $45 and $54 (20 percent) plus the discount rate of about 9 percent. (The discount rate for a stock is sometimes called the required return for precisely this reason.) That would be 29 percent, which is a pretty darn good return, all things considered.

But what if we're wrong? What if Clorox grows even more slowly than "we'd anticipated—maybe a competitor takes market share—or the firm's pricing power erodes faster than we'd thought? If that's the case, then Clorox's fair value might actually be $40, which means we would have overpaid for the stock by buying it at $45.

Having a margin of safety is like an insurance policy that helps prevent us from overpaying—it mitigates the damage caused by overoptimistic estimates. If, for example, we'd required a margin of safety of 20 percent before buying Clorox, we wouldn't have purchased the stock until it fell to $43. In that case, even If our initial analysis had been wrong and the fair value had really been $40, the damage to our portfolio wouldn't have been as severe.

Because all stocks aren't created equal, not all margins of safety should be the same. It's much easier to forecast the cash flows of, for example, Anheuser- Busch over the next five years than the cash flows of Boeing. One company has tons of pricing power, dominant market share, and relatively stable demand, whereas the other has relatively little pricing power, equal market share, and highly cyclical demand. Because I'm less confident about my fore­casts for Boeing, I'll want a larger margin of safety before I buy the shares. There's simply a greater chance that something might go wrong and that my forecasts will be too optimistic.

Paying more for better businesses makes sense, within reason. The price you pay for a stock should be closely tied to the quality of the company, and great businesses are worth buying at smaller discounts to fair value. Why? Because high-quality businesses—those that have wide economic moats—are more likely to increase in value over time, and it's better to pay a fair price for a great business than a great price for a fair business.

How large should your margin of safety be? At Morningstar, it ranges all the way from just 20 percent for very stable firms with wide economic moats to 60 percent for high-risk stocks with no competitive advantages. On aver­age, we require a 30 percent to 40 percent margin of safety for most firms.

Having a margin of safety is critical to being a disciplined investor because it acknowledges that as humans, we're flawed. Simply investing in the stock market requires some degree of optimism about the future, which is one of the biggest reasons that buyers of stocks are too optimistic far more often than they're too pessimistic. Once we know this, we can correct for it by requiring a margin of safety for all of our share purchases.

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