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Margin of Safety 
Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

The extent or degree by which the principal of a loan or issue of securities is protected by property equities and earning power.  The first requisite of a sound investment is safety of principal, and the second is regularity (or prospect of maintenance) of the income.  Strictly speaking, not even the best investment is absolutely safe either as to principal or as to income, and any sum invested must be regarded as carrying some risk.  There is a wide range of risks in the multifarious investment media available, and the degree of safety - or, inversely, the degree of risk - is measured by the margin of safety, also sometimes called the factor of safety.  Specifically, margin of safety refers to separate factors.

Excess Value.  

First, the phrase may apply to the excess value (in dollar amount or in percentage) of the specific lien security, specific pledge of assets or collateral, or general (but unpledged) assets supporting a loan or security issue.  For example, in conservative mortgage finance the amount of the mortgage loan is rarely more than 66⅔% of the appraised value of the mortgaged property.  Thus a mortgage loan of $20,000 on a property appraised at $30,000 would have a margin of safety of $10,000 or 50%.  The protection afforded this mortgage loan may also be viewed as the amount by which the value of the property could shrink and still leave a sum sufficient to pay off the mortgage.  The degree of protection from this viewpoint, which might more logically be called the margin or risk, would also be $10,000, but 33⅓% instead of 50%.

In the case of brokers' call loans on stock exchange collateral, banks require a specific pledge of stocks (or stocks and bonds mixed) which at market value equal from 120 to 130% of the amount of the loan.  The 20 to 30% excess value of the collateral over the amount of the loan is called margin and must be continually kept good.  If the loan is for $100,000 and the market value of the securities is $125,000, the margin of safety is $25,000, or 25%.  The margin of risk, which is the amount by which the collateral security could decline in value and still leave a balance sufficient to pay off the loan, would be $25,000 but 20% instead of 25%.

The margin of safety for the principal of a mortgage bond issue is the excess of value of mortgaged property, or value of the remaining equity if subject to prior lien issues, over the par value of the amount outstanding.  In practice, it is difficult, of course, to determine the market value of properties that are mortgaged, for bond issues - especially railroad and public utility properties.  However, engineering reports are of value in this connection, and in railroad mortgage bond issues there are certain well-established ratios of reasonable bonded indebtedness per mile of road.  A bond issue may have excellent protection for the principal amount even though no lien or collateral security is offered.  If the general unencumbered net assets of a company, conservatively valued, are twice the amount of debenture bonds outstanding and there are no prior bond issues, then the margin of safety for the principal of such a debt would be 100%.

The term "margin of safety" as a measure of the degree of protection afforded the principal sum invested in stocks seems never to have been used, since the value of stocks is usually thought to be dependent wholly on earnings available for such stocks as to bonds or any other form of debt.  For example, if a corporation which has no funded debt, or debt other than current liabilities, has $250,000 in net tangible assets against $100,000 of preferred stock and $100,000 of common stock, the theoretical margin of safety for the paramount of preferred stock would be the excess of net tangible assets over the amount of preferred stock outstanding, e.g., $150,000, or 150%.  Similarly, the margin of safety for the par amount of common stock outstanding would be the excess of the net tangible assets over the combined preferred and common stocks outstanding, e.g., $50,000 or 50%.  If a corporation's books represent the true state of affairs, the margin of safety for the par amount of the common stock would be the amount of the total corporate surplus.  If the common stock were purchased for 50% of par, the margin of safety in equity value would be $100 per share, or 200%.

The margin of safety, expressed either in dollars or as a percentage, shows how much sales can be reduced without sustaining losses.

 Actual sales  -  Break-even sales  =  MS in dollars

 

Excess of actual sales over Break-even sales

 =  MS as a percentage

Actual sales


Excess of Earnings.
  

Second and probably of considerably more importance, is the use of the term to denote the excess of earnings available for the payment of interest charges on a debt (whether short-term or long-term) and of earnings available for the payment of dividends over divided requirements (or current dividend rates).  In bond investments, much importance is attached to the margin of safety, particularly as determined over a period of years, as a key to investment values.  The determination of the margin of safety (earnings available for a bond issue over interest requirements) is normally the chief factor used by various bond rating services in fixing bond ratings.

Wherever a corporation has only one bond issue, e.g., $1 million bearing 5%, and has had an income available for interest changes on this issue for the past five years of $150,000 a year, the average margin of safety is $100,000 a year, or 200%.  In usual parlance, however, it is said to be earning its bond interest charges three times over.  The earnings protection afforded by this corporation for its bond interest requirements, like the property protection afforded the principal amount of a debt as mentioned above, may be viewed as the extent by which the sum available for bond interest charges (usually called gross income or total income) could decline and still cover bond interest requirements.  In this instance, the sum would be $100,000 annually, or 66⅔%.  As stated previously, a more suitable designation for this percentage would be margin of risk.

It is customary in investment circles to regard the margin of safety for a corporation's fixed charges, or for its preferred dividend and common dividend requirements, as the number of times such charges or dividend requirements are earned.  Thus, a corporation having annual fixed charges of $100,000 and earning $400,000 for such charges is said to earn its fixed charges four times over.  The margin of safety - or better, margin of risk - would be better stated as 75%, i.e., the sum available for such charges could decline by as much as 75% and still leave enough to cover such charges.  Likewise, such a corporation having earnings of $300,000 available for its preferred stock on which dividend requirements are $100,000 is said to be earning such requirements three times.  The margin of risk would be computed on the amount by which the sum available for interest charges could decline and still pay all prior charges plus the preferred dividends, i.e., 50%.  If the present common dividend is $100,000 annually (referring to the above example), the margin of safety (or margin of risk) would be computed on the amount by which the sum available for interest charges could decline and cover not only interest charges and the preferred dividend but the common dividend as well, i.e., 25%.

Wherever a corporation's earnings for interest charges are less than the interest charges, a minus margin of safety arises.  For example, if earnings available for interest are $150,00 and interest charges are $200,000, 75% of the charges are being earned, making a margin of safety of minus 33⅓%, meaning that the sum available for interest charges must increase 33⅓% in order to cover such charges.


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