Knowing which stocks to buy is only part of the picture. Investors also need to know when to buy. Are shares a smart buy at $20 each? $75? $400? One of the things that should go into your calculation of when to buy is determining how much of a cushion you want against the chance that the stock won't reach your estimate of its actual market value.
Insisting on this "margin of safety" is one of the five keys to value investing for the team at Motley Fool Inside Value:
The companies we recommend must have excellent management, great assets, strong cash flow, and a competitive advantage. Most importantly, the stock price must be trading at a significant discount to our calculation of intrinsic value. This discount will give us a margin of safety if events don't pan out according to our expectations.
What follows is a modified version of an article Inside Value advisor Philip Durell wrote for service members.
Benjamin Graham, the godfather of value investing and one of Warren Buffett's mentors, regarded margin of safety as the central concept of investing. Margin of safety is simply the percentage below your estimate of value at which you would be willing to buy a stock. Like Graham, we insist on a margin of safety, so we determine a buy-below price for each Motley Fool Inside Value recommendation for you to use as a guide.
The margin of safety is easy to apply if you have some concept of the value of the stock and the relative risk of owning that particular company. For example, we recommend buying Core recommendation Coca-Cola
Every valuation that we calculate includes a range of potential values that we distill into a single intrinsic value, based on the probability that we assign to each scenario. The wider the range of potential outcomes, the wider we set the margin of safety.