What is Margin of Safety

What the heck is Margin of Safety?

Stock Market People talk about this a lot, but they don't use it.

The general idea is that you wouldn't go through a bridge that could only take 1000 pounds if you had a 1000 pound weight, as you would be jeopardizing your safety.

In reality Stock Market people couldn't care less, because they usually don't assess how much a stock it is worth, and since the investment in liquid, they could sell it again and don't care.

Why am i telling you this?

Well, the reality is that this is only valuable when you are buying something with your money and you are putting it at jeopardy. Let's do an example.

Let's say you and i are going to setup a coffee shop in a shopping mall. You nosed around, made some assumptions, and have come up with a rough figure of $15.000 in gross sales every month. What's the problem?If you did your financials right, and assess how much you are going to have to pay for the lease, for employees, taxes, and all sorts of fixed expenses, you now have a solid number of exactly how much you are going to pay, but you are estimating how much you are going to sell, and that presents and issue. On one hand you know exactly how much you have to pay, and it is usually a long 6 year lease contract, but on the other hand you don't know exactly how much you are going to make.

This is where the margin of safety kicks in. You ask yourself: "If i am wrong, is the number of breakeven, reasonable enough?" Essentially what you are asking yourself is: "Am i sure i can make a long term commitment with this educated guess of how mush i am going to sell?Because if i am wrong i would be putting this money and the quality of living of my family to risk". You can know how much are the more experienced players generating in revenue, you can ask more experienced and believable people what is theis assessment and you will come to the conclusion of a number. If you have a significant margin of safety from your assumptions, by comparing to the average of what similar players are doing, you can go ahead, but if not, pass on the opportunity. It is better to not shot yourself in the foot than it is by speculating, hoping for the best when you clearly have proof that probably that is not a good idea.

Don't analysis paralysis, but don't go in without assessing either, as the margin of safety is not that significant when you can get your money back again, but it is 100% significant when you are putting money on something that might mean a complete loss.

Be great, as nothing else pays,

DM