Margin of SafetyDefined with Formula & Examples

Lisa Borga
Last Updated: January 7, 2022
Date Published: January 7, 2022

The margin of safety for a business is a way of measuring the profitability of a business.

It is obtained by taking the difference between a business’s revenue and its break-even point, which is the point at which a business’s total revenue and total costs are equal.

The Formula for Margin of Safety

The Margin of Safety can be calculated by subtracting the break-even point of a business from its total revenue.

The margin of Safety = Total Revenue – Break-Even Point

However, there are other ways of calculating the margin of safety.

It can be calculated as a percentage, as follows.

Margin of Safety = [(Revenue – Breakeven Point)/Revenue] * 100

It can also be expressed in terms of units, as shown:

(Total Revenue – Breakeven Point)/ Selling Price per Unit

margin of safety

Using Margin of Safety

The margin of safety is particularly useful for businesses in the two following areas.

Budgeting

When creating a budget, the margin of safety is the difference between a business’s expected sales and the point at which sales would no longer be profitable.

This allows a business to see how much its sales can decline before losing money.

This is particularly useful if the company is expecting a downturn in business.

If the company discovers it has a low margin of safety, it might want to consider cost-cutting measures.

Whereas, if it has a high margin of safety, it can feel a bit safer knowing that it can handle some variability in sales.

Investing

The margin of safety is a bit different in investing; instead of being the difference between total revenue and the break-even point, it is the difference between the intrinsic value of a stock and the current market price of the stock.

The intrinsic value of an asset is its actual value, that is, the present value of the asset found by calculating the total discounted future income it’s expected to generate.

When using the margin of safety in investing, assumptions need to be made in order to calculate the value.

Therefore, an investor would only want to buy a security if its market price is significantly lower than its intrinsic value.

There is no definitive way to calculate the intrinsic value of a stock because investors use different methods of determining this value, and these methods may not be accurate.

In order to get a fair and objective value of a business, the security’s fair market value is necessary so that the investor can use the discounted cash flow analysis method.

Example

A coffee shop wanted to buy a new espresso machine, but they decided to first calculate their margin of safety to ensure they could afford it.

To do this, they used their current sales revenue of $60,000 and their break-even point of $45,000.

They found their margin of safety was $15,000 or 25%.

$60,000 – $45,000 = $15,000

-OR-

[($60,000 – $45,000)/$60,000] * 100 = 25%

This business needs to decide if they feel comfortable purchasing the new machine with this margin of safety.

If they are not comfortable buying the machine with the current margin of safety, they may want to consider trying to lower expenses before buying the machine.

margin of safety

What is Considered a Good Margin of Safety for Investing?

A good margin of safety for investing really depends on an individual investor’s preferences.

However, generally, a higher margin of safety will reduce your investment risk.

If an investor buys a stock below its intrinsic value, the potential for losses is usually lower.

So, using the margin of safety can help lower potential losses.

Is the Margin of Safety Useful?

A high margin of safety is considered good.

It tends to show that a business is performing well and can withstand a fair amount of sales volatility.

Whereas, if a business has a low margin of safety, it might not be able to withstand very much volatility in its sales.

It might need to improve its position by charging more for its products, increasing its sales, finding a more profitable product mix, or reducing its variable costs, thereby increasing its contribution margin.

Choosing a stock with a higher margin of safety gives an investor a bit of protection against errors in their calculations when choosing a stock.

It can be hard to determine the fair value of a stock, and a high margin of safety can give the investor some room for error.

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  1. BYU Idaho "Margin of Safety" Page 1. January 7, 2022

  2. State University of New Jersey " Develop a Financial Margin of Safety" Page 1 . January 7, 2022

  3. Jiwaji University "Margin of Safety" Page 5 - 6. January 7, 2022