Margin of Safety Formula

What Is Margin of Safety?

The margin of safety (MoS), also called the safety margin, is an accounting metric and a financial ratio. In accounting, it is used to calculate the difference between actual sales and the break-even point. A company reaches the break-even point when its sales cover all its total costs. 

In investing, the safety margin is the difference between the intrinsic value of a company’s stock and its market price. It is a concept made popular by value investors such as Benjamin Graham and Warren Buffett.

As per Warren Buffett’s letter to his shareholders, Chapter 20 of the book “The Intelligent Investor by Benjamin Graham” which deals with a margin of safety, is the most important chapter that any value investor must read.

The margin of safety in break-even analysis and budgeting is an important risk management technique that flags potential profitability concerns. It helps understand the sales a business should generate to cover its fixed cost. 

If the sales are below the break-even point, the gross profit from it won’t be enough to cover the fixed expenses, which would mean that the company would incur losses.

Profitable companies have actual or real sales that exceed break-even sales. The margin of safety can also be applied to unit sales or dollars. In this case, it expresses the ratio between actual unit or dollar sales and unit/dollar break-even sales. 

Hence, MoS is a very important tool in corporate finance that helps to set targets for the company in terms of sales and overall performance.

What Is The Margin Of Safety Formula?

The Margin of Safety measures financial risk by comparing actual sales to the break-even point in accounting and intrinsic stock value in investing.

The margin can be expressed in three ways:

1. Expressed as a ratio

The margin of Safety is as follows: 

Margin of Safety = (Current Sales - Break-Even Point) / Current Sales x 100 

2. Expressed in terms of the sale of units

To calculate, the formula is:

Margin of Safety in units = Current Units Sales - Break-Even Units Sales

The break-even unit sale can be calculated by dividing fixed costs by the contribution margin per unit.

Contribution Margin per unit = Sale Price per unit - Variable Cost per unit

3. Expressed in terms of Dollars of sale

The safety margin expressed in dollars can be calculated in two ways: 

The margin of Safety in Dollars = Current Dollar Sales - Break-Even Dollar Sales

where,

Break-even Dollar Sales = Fixed Cost/ Contribution margin

or

Margin of Safety in Dollars = Margin of Safety in Units x Price per Unit

A positive safety margin is what all businesses should aim for since it is generally desirable. Although there isn’t a set range for a good MoS, the higher the margin, the better.

Different companies and industries will have different safety margins. High safety margins allow companies to weather a drop in sales or negative market conditions such as supply chain issues.

• Higher margins of Safety also signal that a business has the ability to invest in projects, which can boost future growth and revenue.
• Conversely, a low margin of Safety is a reason for concern as the company may not be able to generate the required profit and might be on the road to insolvency.

The low margin sends a clear message to managers and executives that the company has to reduce its costs or make other changes to its operations (such as changing products in case the supply for the current product far exceeds its demand).

Margin Of Safety Practical Example

The margin of safety formula is most commonly used in manufacturing and retail businesses.

For example, you are selling ten widgets for $20 per widget, with the desired profit of $5 per widget. The break-even point would be:

(10 * $20) - (10 * $5) = $150

The break-even in units will be:

$150/ $20 = 7.5

The margin of Safety stands at 2.5 (10 - 7.5) widgets or $50 (2.5 * $20).

We’ll take another example to help us understand the concept better. Suppose there is a small business that sells handmade jewelry. Their current sales for the year amount to $50,000, and the break-even point is $40,000.

Using the formula, we can calculate the Mos:

Margin of Safety = (Current Sales - Break-Even Point) / Current Sales x 100

Margin of Safety = ($50,000 - $40,000) / $50,000 x 100

Margin of Safety = (0.20) x 100 = 20%

Here, the Mos arrives at 20%. Upon interpreting this, the 20% means that the current sales of $50,000 are 20% higher than the break-even point of $40,000.

This 20% margin of Safety indicates that even if the sales were to decrease by 20%, the business would still cover all their costs and break even. It provides the business with a buffer against a drop in sales and gives some financial stability in case of unforeseen challenges or market fluctuations.

Investing And Margin Of Safety

The Margin of Safety in investing is the difference between the intrinsic value of a company’s stock and its current stock price. Intrinsic value simply means what a company or an asset is worth.

The intrinsic value of a stock can be higher or lower than its current trading price. 

• A lower intrinsic value signals that the security is trading at a premium
• A higher intrinsic value means that it trades at a discount

When the intrinsic value of a stock is higher than its current price, it means that the stock is undervalued, which is a good buying opportunity. It is associated with value investing, which is endorsed by some very successful investors like Benjamin Graham and Warren Buffett.

The margin of Safety in investing represents buying a security at a discount relative to its intrinsic value. Even if the margin of Safety might cushion downside risk, investing always has a risk. However, this metric is less useful in some investments, as one WSO forum user has remarked.

"The margin of safety is subjective and dependent upon the investment. Almost all LBOs are intermediated, and as such, you are rarely able to acquire a profitable company at a meaningful discount to intrinsic value.

In a more distressed situation, you might derive a margin of safety based on liquidation value or a low multiple of the profitability from, for example, a particular business segment that is obscured by other unprofitable operations. But those aren’t really 'LBOs.' " 

The discounted cash flow (DCF) method is a common approach to calculating the intrinsic value. Using this model, the intrinsic value of a stock is achieved when the appropriate discount rate discounts estimated future cash flows to obtain their present value.

The sum of the present value of cash flows is then compared to the current stock price.

Margin Of Safety Benefits

The key benefits of using this metric are:

1. Early Warning for Management

It alerts company management about potential areas of concern, especially when there is a decline in sales. Managers will have to take appropriate actions, including but not limited to cutting costs, identifying underperforming product lines, or reviewing prices.

2. Guiding Sales Targets and Rewards

It helps to set sales targets that the sales department is expected to achieve, thereby providing them with guidance. It also helps set a bonus structure that rewards them for meeting these targets.

3. Spotlight on Cost Efficiency

It helps identify the major cost components for cost accountants, who can determine which areas need more attention to reduce costs and increase contribution per unit.

4. Balancing Fixed and Variable Costs

It provides guidance to managers who must choose between reducing fixed costs while increasing variable costs and vice versa.

For example, a factory could choose to automate the production process and let go of employees or hire employees while reducing the amount of automation. While the former is usually preferable, the decision is never straightforward.

5. Risk Gauge for Investors

It helps investors to account for risk in their investments. For example, a company's stock with an MoS of 20% is less risky than one with an MoS of 5%. 

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Angel Investor
• Annual Equivalent Rate (AER)
• Income Tax Payable
• Justified Price to Earnings Ratio
• Net Debt-to-EBITDA Ratio