Keeping an eye on outgoings and profit margins is something that many firms do, but it’s also crucial for company accountants to keep an eye on the margin of safety. Let’s see how to compute the margin of safety formula.
What Is the Margin of Safety?
The margin of safety is an investment idea that states that an investor should only buy securities when their market price is much lower than their true worth. In other words, the margin of safety is the gap between the market price of a security and your estimate of its intrinsic value. Because investors can define their own margin of safety based on their risk tolerance, purchasing securities when this disparity exists provides a low-risk investment.
In accounting, the margin of safety, often known as the safety margin, is the gap between actual and break-even sales. Managers can use the margin of safety to determine how far sales can fall before the firm or project becomes unprofitable.
Understanding the Safety Margin
There are two methods for determining the margin of safety:
#1. Creating a budget
The margin of safety in budgeting and break-even analysis is the difference between the expected sales production and the level by which a company’s sales could decline before becoming unprofitable. It alerts management to the risk of loss that may occur as the business is susceptible to changes in sales, particularly when a large portion of sales are at risk of declining or becoming unprofitable.
A low percentage of the margin of safety may cause a corporation to minimise expenses. However, a high spread of margins ensures that a company is shielded from sales volatility.
#2. Making an investment
The margin of safety in investing refers to the difference between a stock’s intrinsic value and its current market price. The intrinsic value of a company’s asset is the true worth of the asset or the present value of an asset when the total discounted future income earned is added up.
When it comes to investing, computing the margin of safety uses assumptions, which means that an investor would only acquire assets if the market price was significantly lower than the projected intrinsic value. Determining a security’s inherent value or genuine worth is highly subjective because each investor uses a different method of calculating intrinsic value, which may or may not be accurate.
To use the discounted cash flow analysis approach to get an objective, fair valuation of a business, the fair market price of the security must be known.
That provides a 1000-unit cushion before the business becomes unprofitable, i.e., Company A might lose 1000 sales and still break even, and the 1000 sales over break even directly translate into profit. Businesses can use this data to determine whether or not to expand or reevaluate their inventory, as well as how secure they are going forward. Seasonal commodities, for example, may need to keep this margin in mind as they navigate off-peak sales times.
What is the Formula for the Margin of Safety?
The margin of safety is computed in accounting by deducting the break-even point amount from actual or forecasted sales and then dividing it by sales; the result is represented as a percentage.
Margin of Safety = (Current Sales Level – Breakeven Point) / Current Sales Level x 100
You can state the margin of safety formula alternatively in terms of dollars or units:
Dollar Margin of Safety = Current Sales – Breakeven Sales
Unit Margin of Safety = Current Sales Units – Breakeven Point
As an example,
Ford Motor Company purchased additional gear to increase the output of its top-of-the-line automobile model. The machine’s costs will raise annual operating expenses to $1,000,000, yet sales output will grow as well.
Following the purchase of the equipment, the company generated $4.2 million in sales revenue, with a breakeven point of $3.95 million and a margin of safety of 5.8 percent.
What is a Good Percentage of Margin of Safety?
In general, the greater your margin of safety, the better. Your protection against bankruptcy, which will vary depending on your firm, is what your margin of safety represents.
For example, if your margin of safety is roughly £10,000 and your selling price per unit is £5,000, you can only lose two sales before your business is in serious trouble. So, while £10,000 may be a significant cushion for certain organisations, it may be insufficient for others.
In the case of units, the margin of safety formula is as follows:
(Actual Sales – Break-Even Point) / Selling Price Per Unit = Margin of Safety
This means that if Company A sells a unit for £100, the margin of safety formula would look like this:
(£200,000 minus £100,000) / £100 = 1000
What is the Optimal Margin of Safety for Investing?
One can determine the extent of the margin of safety based on the investor’s preferences and the sort of investment he selects. Some of the scenarios that an investor may be interested in if there is a significant margin spread are:
Deep value investing is purchasing equities in significantly undervalued companies. The primary purpose is to look for big discrepancies between current stock prices and the intrinsic value of these stocks. This sort of investment necessitates a huge amount of margin to invest with, as well as a lot of guts, as it is dangerous.
Investing in growth at a fair price entails selecting companies with positive growth rates that are somewhat lower than their real value.
How Important Is It?
A high safety margin is recommended since it signifies strong business success and provides a large buffer to absorb sales fluctuations. A low safety margin, on the other hand, implies a less-than-ideal situation. It needs to be enhanced by raising the selling price, boosting sales volume, enhancing contribution margins by lowering variable costs, or switching to a more profitable product mix.
For investors, the margin of safety acts as a buffer against calculation errors. Because fair value is difficult to anticipate properly, safety margins safeguard investors from bad judgements and market downturns.
Advantages of Margin of Safety
- Allows for error: Investing in equities with a high margin of safety provides a safety net in case you’re wrong.
- Assists you in accounting for multiple risks: To generate a sufficient margin of safety, you must account for a variety of risks, including company-specific, stock market, and human error.
- Prevents you from following the herd: Many investors overpay for stocks because they follow the latest fad. Investing only when there is a large margin of safety allows you to avoid making judgements based on hype.
Disadvantages of Margin of Safety
- Based on subjective factors: The margin of safety necessitates calculating the stock’s intrinsic value, which varies greatly depending on the strategy and the individual investor.
- Does not guarantee returns: While investing with a margin of safety is an important risk management method, it does not remove risk. Even a large margin of safety does not guarantee that you will not lose money. Furthermore, investing with an excessively wide margin of safety may diminish your returns.
- Less suitable for growth investors: A big margin of safety is less necessary for growth investors, who are willing to tolerate higher risks in exchange for higher profits. Calculating the intrinsic worth of a company in an emerging industry can be difficult. A growth investor, on the other hand, is less concerned with finding a bargain and more focused on maximising profits.
The Distinction between Breakeven Point and Margin of Safety
The break-even point (BEP) is the sales level at which the sum of fixed and variable costs equals total revenues. In other words, the breakeven point is the point at which the company does not make a profit or a loss.
A margin of safety (MOS) is the difference between actual/budgeted sales and the breakeven sales level.
Although the breakeven point (level) and margin of safety are both parts of the cost-volume-profit analysis (CVP Analysis), they differ in several ways. The following are the main points of distinction between the breakeven point and the margin of safety:
The term “breakeven point” refers to the quantity of revenue that covers all fixed and variable costs. Sales below the BEP will result in losses, while sales over the BEP will create profit after deducting all costs.
The margin of safety, as the name implies, is the difference between actual and budgeted sales and the breakeven threshold. It denotes the level of safety that a corporation has prior to suffering losses (i.e. falling below the breakeven level).
Breakeven Point and Margin of Safety Interpretation
The breakeven threshold measures sustenance, whereas the margin of safety measures risk.
The lower the breakeven quantity, the better for the company, but the bigger the margin of safety, the better for the company.
Problems with the Margin of Safety
When sales are highly seasonal, the margin of safety idea does not work well since some months will provide disastrously poor results. In such circumstances, annualize the data to incorporate all seasonal swings into the final result.
Value Investing and Risk: Margin of Safety
From a risk perspective, the margin of safety serves as a buffer built into their investment decision-making to protect them from overpaying for an asset, i.e., if the share price drops significantly after acquisition.
Instead of shorting stocks or buying put options to hedge their portfolio, a large proportion of value investors consider the margin of safety to be the primary method of managing investment risk.
When combined with a longer holding period, the investor is better able to resist market pricing volatility.
In general, most value investors will not buy an asset until the margin of safety is considered to be between 20 and 30 percent.
If the investor’s margin of safety is 20%, he or she will only buy a security if the current share price is 20% less than the intrinsic value based on their valuation.
If there is no “room for error” in the valuation of the shares, the share price will be lower than the intrinsic value in the event of a modest fall in value.
Accounting Margin of Safety (Break-Even Example)
While the margin of safety is linked with value investing, owing partly to Seth Klarman’s book, the word is also used in accounting to evaluate how much excess income is earned over the minimum amount required to break even.
From a different perspective, the margin of safety is the entire amount of sales that a company could lose before it begins to lose money.
The formula for calculating the margin of safety includes knowledge of the company’s expected revenue as well as break-even revenue, which is the point at which income sufficiently covers all expenses.
