Margin of safety. Warren Buffett calls them "the three most important words in all of investing." Value-investing dean Benjamin Graham gave rise to the term in his classic book The Intelligent Investor, where he devoted an entire chapter to expanding on its importance as the central concept in any investment operation.

The idea of a margin of safety stems from the reality that no investor, not even Buffett, can determine the exact intrinsic value of any business. Because the intrinsic value is derived from an investor's assumptions, the value is merely an approximation. Yes, an investor as skilled as Buffett will probably have a better approximation of intrinsic value than most, but it is still an approximation nonetheless.

This is why the margin-of-safety concept is of paramount importance. It gives the investor a degree of protection from the market's uncertainties. A margin of safety of at least 40% of intrinsic value typically proves satisfactory, although the wider the margin, the better. In any event, you will rarely lose money investing if you always demand a satisfactory margin of safety.

And demanding one means that your first goal will be to focus on return of -- not on -- capital. Once you've determined a floor price based on a fundamental valuation approach, then investing at or below that floor price ensures that your return of capital is not at a high risk of loss.

Sniffing out discounts
The most common type of margin of safety occurs when a company's tangible assets far exceed its market value. Graham was famous for seeking out net-net values, or securities selling for less than two-thirds of current assets, less all liabilities. That's the ultimate margin of safety. But as more investors have entered the game, these special situations have become exceedingly more difficult to find.

Yet it is still possible to find businesses that trade at significant discounts to intrinsic value. Let's examine two examples -- one from the more distant past and one from a couple of years back.

Washington Post, 1971
During the early 1970s, Mr. Market got too emotional with media companies, and their stock prices suffered. That spelled bargains for the enterprising investor. And that's when Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) jumped in, to buy a stake in Washington Post (NYSE:WPO).

At the time, Washington Post was the publisher of a first-rate newspaper and also held a valuable collection of media assets. Buffett concluded that the company could fetch some $400 million in a fire sale of the assets. Yet Mr. Market was selling the entire company for less than $100 million. This was a margin of safety of more than 75%, and Buffett invested big.

Buffett determined the value of the assets by looking at what the market had paid for similar businesses over the years. Yet even if Buffett's numbers had been off, his margin of safety was so high that his downside was virtually assured. His return of capital was guaranteed. Even if Buffett was off by 25% and the assets were worth $300 million, paying $100 million was still a very satisfactory margin of safety. Since 1973, Buffett's $11 million investment is worth more than $1 billion.

Sunrise , 2003
Back in 2003, I began accumulating shares in Sunrise Senior Living (NYSE:SRZ), a company that specializes in assisted-living facilities. At the time, a lot of competitors were being swept away because of overleveraged balance sheets and high costs of capital. And Mr. Market was punishing Sunrise along with everyone else.

But looking at Sunrise, I saw some promising signs:

  • Sunrise clustered its facilities in top metropolitan areas, with several facilities per cluster. This approach allowed for very strong operating efficiencies.
  • There are many high barriers to entry in this sector, specifically capital and time. It takes about four years for a facility to become cash flow-even, so a strong balance sheet and economies of scale are vital.
  • Sunrise was making money two ways: by selling existing properties and managing properties on a fee basis.

Looking back over several years, I discovered that Sunrise was selling its existing properties for an average of 50% over their stated book value. So it was safe to deduce that the $800 million of property on the balance sheet was worth about $1.2 billion, or about $33 a share at the time. The management division was on track to earn $1.29 per share in 2003, so applying a conservative 12 times earnings to this segment meant a value of approximately $15.50. Thus, a good intrinsic-value estimate of Sunrise was around $48 to $49 a share. At the time, the shares were trading at $28 to $32 a share, or a 50% discount to intrinsic value. Sunrise was also being run by the husband and wife who founded the company and still owned 10% of it.

So not only was there a satisfactory margin of safety, but the company was also well run by able and honest management. Sunrise now trades at just less than $40 after a 2-for-1 split -- not a bad return on capital in four years.

Remember the intrinsic value
Keep in mind that a margin of safety is affected by the intrinsic value of the business. When the intrinsic value changes, so does your margin of safety, and you'll need to determine whether to keep holding the position or dispose of it.

Let's face it: In investing, nothing is a sure thing. Even the most astute investor can get burned by the market's whims. A satisfactory margin of safety gives you the next best thing, and a value investor always demands it from his or her investments.

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Sham will discuss intrinsic value in his follow-up, "Security Analysis 201." But if you want to get a head start on some great value picks, head on over to The Motley Fool's Inside Value newsletter service for a free trial. The picks at Inside Value are beating the market by 7 percentage points.

Fool contributor Sham Gad runs the Gad Partners Funds, a value-centric investment partnership modeled after the 1950s Buffett Partnerships. He owns a stake in Berkshire Hathaway, which is a recommendation in Inside Value and Stock Advisor. Reach him at The Fool's disclosure policy is designed for safety.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.