According to the man who taught Warren Buffet how to invest the three most important words in investing are: margin of safety. In his book, The Intelligent Investor, Benjamin Graham wrote: “The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price.” From The Telegraph’s “How to Invest Like…Benjamin Graham”:
Graham brought this idea to life with his invention of a character called “Mr Market”.
Imagine, he said, that you own a small share of a business in which one of the other shareholders is a man named Mr Market. Every day, Mr Market tells you what he thinks your shares are worth: he says he will either buy your shares or sell his to you at the same price.
But Mr Market, Graham said, is something of a manic depressive and the price he quotes for the shares in your business swing wildly from one day to the next. In particular, they often bear no relation to the state of the underlying business.
So one day he may be in a depressed mood and quote you a price that significantly undervalues the business, in which case you may decide to buy his shares and increase your stake on the cheap.
But on another day Mr Market may be feeling irrationally optimistic and decide that your shares are worth far more than what you regard as their true value. This time you may decide to sell them to him for a handsome profit.
Instead of believing that the prices offered by Mr Market painted an accurate picture of your company’s worth, Graham said it was vital to form your own idea of its true or “intrinsic” value.