Margin of Safety

The margin of safety is a concept tightly linked to the concept of intrinsic value. Without an intrinsic value, there can be no way to determine how large (or small) your margin of safety is. Understanding this relationship is important when trying to minimise risk in security investments.

Intrinsic Value
Intrinsic value is true value of an underlying investment based on factual information. Warren Buffet defined intrinsic value as "the current discounted value of the future cash flows that can be taken out of a business" whilst Ben Graham defined it as "the value which is justified by....assets, earnings, dividends and definite prospects".

Margin of Safety
Without an understanding of intrinsic value then this difficult to determine. This can be defined as the spread between the purchase price per share and the actual calculated underlying value per share. The wider this spread, the greater the buffer the investor has against downturns in the market and bad investment decisions brought about by the difficulties in evaluating businesses.

Simply, if you can't work out the intrinsic value for your business then how will you know what price to pay?