Margin of Safety
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.
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%.
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%.
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%.
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%.
margin of safety, expressed either in dollars or as a percentage, shows
how much sales can be reduced without sustaining losses.
Break-even sales =
MS in dollars
Break-even sales =
MS in dollars
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.
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.
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.