A stock’s intrinsic value is a function of a variety of factors. There are financial factors like growth in sales, growth in profits, operating margins, P/E ratio, dividend yield etc. Then there are non-financial factors like the management quality, entry barriers created by the product, corporate governance standards, brands and other intangible assets of the company. The final valuation is arrived at by combining the impact of financial and non-financial factors. It is normally arrived at by discounting future cash flows and then adjusting it with the peer group P/E ratio and other qualitative factors. The output is the intrinsic value of the stock.
The intrinsic value is actually useful if looked at with reference to the market price of the stock. A stock is said to be underpriced if the market price is below the intrinsic value and it is considered to be overpriced if the market price is above the intrinsic value. But the big question is by how much is the stock overpriced or underpriced. This gap between the market price and the intrinsic value is referred to as the margin of safety. From an investor’s point of view, if the market price is substantially lower than the intrinsic value of the stock then the stock offers a high margin of safety and it is a good stock available for investment at an attractive level.
On the other hand, from a seller’s perspective, if the market price is substantially higher than the intrinsic then it offers a higher margin of safety to sell or short the stock. Thus margin of safety works both ways, although it is popularly used to refer to a situation when stocks are deeply underpriced. Even when major investors decided to exit the stock, they look at the margin of safety. For example, if the stock is 80% above the intrinsic value then there is a lot more of business sense in selling these stocks than when the intrinsic value is just 15% lower.