Preston Pysh 5:34
Okay. So that’s, that’s obviously a great question. You know, so you would look at the business, you’d see what it’s doing. And like Stig said one of the first things you want to know as an investor if you’re getting ready to own this business, let’s just call it a coffee shop on Main Street, you’re not going to go and buy this coffee shop if it’s not even profitable, okay? And I can tell you right now that might sound like a really basic question and something that doesn’t seem like it’d be, oh well, that’s, that’s obvious. But it’s not obvious because when you go on to the stock market and you look at businesses, you know, you might find that 30% or even higher are not even profitable, okay? And I think a lot of people have no idea and they really don’t understand that. So, Stig asked the question, “How much money is this small business making? How much is this, is this coffee shop making?” Okay, and so let me just come up with a generic figure to go back to him. Well, my coffee shop is making $10,000 a year after all of my employees are paid. That’s the money that’s sitting in my cash account in my bank account. There’s $10,000 of profits sitting there. So then, Stig, how would you, you know, how would you handle that? When you think about that response?
Stig Brodersen 6:43
Well, yeah. So first of all, I would need to make sure that it’s 10,000 every year. And of course, here in life, there are no certainties. But, do we expect the coffee shop to be something that we can hope for the long run, Preston? Do we expect 10,000 every year?
Preston Pysh 6:58
Yeah, and I think that for, are the basic scenario that we’re talking here, yes! Let’s, let’s make that assumption that every year, let’s say like last year, it was 9,500. This year it was 10,500. And you’re kind of, you’re right in between that 10,000 mark every year. As far as like in the town, you’re the only coffee shop. You don’t really see the potential for competitors. Just to kind of keep this scenario really basic and understandable.
Stig Brodersen 7:22
Okay, so if I could make $10,000 every year by owning this coffee shop, I would probably say something like a hundred thousand. I guess I would multiply it by ten. That’s a really good rule of thumb.
Preston Pysh 7:33
Okay. So what Stig did here is…in investing you’ll typically hear things called a P/E ratio, and we’re not going to get too in depth into some of the terminology because we’ll do that in following episodes. But with the P/E ratio is, is the price compared to the earnings. The price divided by the earnings. So when we talk about profit and investing, this is probably one of the most important terms you can understand, and this is something that you definitely want to take away from this episode. The profit; the bottom line; what the company’s making. That is often referred to as earnings or net income. So those are two terms that you absolutely got to understand, and don’t forget because when you hear earnings or net income that means profit. That’s that bottom line, okay?
Stig Brodersen 8:20
So in this situation, the P/E or the priced earnings that is ten. So that means I am spending a hundred thousand dollars to get 10,000 back in one year. Or you can also just say it cost me $10 for every dollar of the profit in the company.
Preston Pysh 8:36
Okay, so whenever you’re investing, and so you might hear people at work they’re, they’re constantly saying, “Oh, what’s the P/E ratio? What’s the P/E on that company?” Well, that’s exactly what we just described, okay? That’s the price to the earnings of the company. And the thing that you really got to think about is what does that ratio represent when you say the P/E is ten? Well, that’s the multiple. That’s ten times the earnings or the profit that you’re willing to pay for the company. So when you look at it that, in that light, what you can do is you can quickly understand what’s your return, okay? If that $10,000 a profit or earnings remains constant year after year, and he paid $100,000 to own it. Well, his return is 10%. Because 10,000 divided by 100,000 is 10%. So you can quickly see how, you know, whenever you’re buying that small business on Main Street, the first thing you want to know is how much money is this thing going to make or you’re just not going to buy it. I mean, if, if he was trying to buy this company, and he knew that the profit was 10,000, and maybe he paid 300,000 for it. Well, he’s already handicapped his future return because he’s only going to make a three or 4% return by owning that coffee shop because of the high price that he would have paid. So that’s the thing that really sets Warren Buffett apart from any other investor is he always does this value equation. He figures out what is this company worth before he goes out and buys it. And that’s what a lot of people, they never make that step, okay? They’ll go and buy a stock, and they’ll buy that stock because they like it or because it, you know, if it’s an Apple phone, I really like my Apple phone in my pocket. And so they’ll just go buy Apple, but they never think about, “Well, how much is this company worth? What am I buying this company for?” And when you’re doing that on, on Main Street, you’re doing that with that small business. The first question you ask is, “What’s it worth?” And unfortunately, in stock investing that’s the last question people ask. And that’s what sets Warren Buffett apart from them is, he asked that question first, instead of last. And he treats it just like any other small business that you would find in your local town. So, Stig, you had something that you wanted to add?
Stig Brodersen 10:43
Yeah, so we talked about that. It’s really important to ask the first question here, which is, “How much money is the company making?” But as Preston is saying, “The, the question you need to ask just after that is, ‘How much do I need to pay for that?’” And this is really where this price-to-earnings comes into the picture. So what Warren Buffett is doing is that he wants to find a company with a low price-to-earnings ratio. Now clearly that we have a lot of different metrics here, but this is one of the most important one, to have the lowest price to earnings as possible.
Preston Pysh 11:15
And, you know, as we get into further episodes we’re going to further define this because it’s just not, I mean, we’ve made this sound extremely simple, you know? And it is pretty simple. But there are further metrics in order to come up with a proper valuation of a company, so I just don’t want people to go out and just start acting on some of this information without going into further episodes or doing more research. But the important part is, you have to figure out what’s it worth. Okay, first. And then, second of all, you have to say, “Well, what’s the person willing to sell it for?” Because, you know, you might determine, “Hey, I’m willing to pay ten times earnings for this small business which will give me a 10% return.” But if you go to the owner and they want to sell it for 300,000, you know right then and there that because of that purchase price that the person wants to sell it for, if you buy it at that price point, you’re already handicapped to a 3% return on your money. So you got to think of investing anytime you buy anything, you need to think in those terms first. What is the return that I’m gonna get? First and foremost, that’s up front, okay? Because you know that if you’re going to get a 3% return or a 1% return on something that’s high risk, your analysis can stop right there. You don’t have to spend any more of your time in order to research that. You can just, you know, cut all ties. So, yeah. Go ahead, Stig!
Stig Brodersen 12:31
Yeah, and that’s really the, the beauty about stock investing. You don’t have to buy. I think Warren Buffett refers to this as you don’t have to swing at every pitch. So if you don’t like the price, if you really only want to buy a…shares in companies with a price earnings below 10, which means you get a 10% return. Then, you can just choose to buy these companies or you can just wait till really good companies are very cheap.
Preston Pysh 12:55
Yeah, so and real fast. Let’s, and we gave you a scenario where the price would have been higher, which would have been thirty times earnings at 300,000. But let’s just say that the price that the person came back, let’s say they were willing to sell it for $50,000, okay? So right there, now you’re, now you’re in a completely different situation where you’re gonna get 20% return on your money because you’re going to make $10,000 on the purchase price of 50,000. So without talking into too much of the specifics, I think, you really understand what we’re trying to get at here is you have to understand what the profit of the company is versus what you’re paying for it. And that is first and foremost how Warren Buffett sees things. So the next thing that we want to talk about here is we want to talk about how one share of a business is exactly the same as owning all the shares of the business, okay? And that’s the next thing that separates Warren Buffett’s thinking from the rest of, you know, a lot of investors is, when he buys one share of Coca-Cola, he looks at that ownership of that one share as in the same exact light as if he owned every single share of the business, okay? And when you make that leap; when you make that jump, it’s literally like a quantum leap in understanding for stock investing because what you’re going to start doing here is you’re gonna value that one share as if it’s, if it’s an entire business itself, okay? Go ahead, Stig.
Stig Brodersen 14:17
Yeah. So what, what Warren Buffett is doing is that he is making business decisions. He’s not making stock decisions. And I think to distinguish, to distinguish between those two, I think that’s really, really important. So if he buys stock in Coca-Cola for instance, he is making a business decision that he likes Coca-Cola; that he thinks it’s a great business. And that’s really not the same as doing stock investing. Well, again, that depends on how you define that. When a lot of people are thinking about stock investing, they think, “Okay, I buy a stock for $100. Hopefully, will increase to like $110 in a week from now. But that’s not how Warren Buffett looks at it. He looks at the business. And if he likes the business, if that business generates profit, well, he would benefit that with the, with the highest stock price later on, anyway.
Preston Pysh 15:06
Yeah, so I think what a lot of people don’t understand is what is a share, okay? And what a share is, is it’s a proportional ownership of equity in a business. So going back to our main street coffee shop, okay? That coffee shop, let’s say Stig was purchasing that coffee shop for $100,000. Let’s also say that there are, that we take that company, that one company, and we divide it up into a bunch of shares, okay? Let’s divide it up into 10,000 shares, so one share is the same as owning all 10,000 shares from a proportional valuation standpoint. So if we would divide that hundred thousand company; let’s say he bought that business for $100,000. If we divided it into 10,000 shares, each share is going to be worth $10 a share based on that purchase price. So that’s how things get a little confusing for people is they would, let’s say that it was on a stock market and you could buy it for $11. Well, if you could buy that one share for $11 that basically changed the valuation of the company to $110,000 immediately, okay? And that’s where people will kind of lose sight of this. They, they don’t treat that individual share price in the same proportional light that you would value the entire business. But when you understand that one share is the same as owning all the shares, all of that starts to change, okay? It’s all proportional.
Stig Brodersen 16:32
And I think that’s, that’s because when it’s a share, it’s only part of the company. And I think that that’s difficult for many people to get a grasp on. So say that you want to buy a car for instance. Well, some people might, might think that the car’s worth 10,000 or 11,000. But most people have a general idea of what, how much is the car worth. When you’re buying a fraction of a company, say that you’re buying one millionths of Apple. Well, how much is that really worth? And that’s much harder for people to valuate.
Preston Pysh 17:03
That’s spot on! That’s exactly the part that, that you really need to understand. Taking away from this episode, that’s what we need to hammer home is that point right there. One share is exactly the same as all the shares, and you need to do the valuation of what you think that that one share is worth. And when you do that, you’re going to be thinking in the same space, the same light that, that Warren Buffett thinks whenever he makes a business decision as, as Stig so eloquently said. So the next thing that, that you’re gonna be looking at whenever you’re buying stock is now that we understand this idea that one share is the same thing as owning the entire business. Now, all of a sudden, we want to start buying quality businesses. We want to buy businesses that have low amounts of debt. We want to buy stable businesses. We want to buy businesses that we understand. And so, whenever you understand what it is that a share actually represents, it’s amazing because your whole mindset, the way that you see things truly start to take a, an immediate turn from the way that you might have been previously investing. So let’s quickly talk about this quality aspect of investing. So whenever you’re buying a business, do you want a business that has a lot of competitors; that has a product that has low margins? And I think the answer is obviously no. So when you buy a company that, that is high quality; that has a good brand; that you feel is going to be around for the next 20 years; that’s a business that’s worth owning. And that’s a business that’s going to continue to give you those returns that you have a general idea of what you think you’re going to get back like the coffee shop, and that’s when you can really start seeing long term success. And Stig, I saw you had a point you wanted to say.
Stig Brodersen 18:45
Yeah! If you ever listened to an interview with Warren Buffett, you will often hear him talk about “Moat.” When he was talking about “Moat,” this is actually another word for a competitive advantage. So Preston was saying before, “Do we want a company that has a lot of competitors?” Well, clearly we don’t. But in the end of the day, almost all companies have their competitors. But if you have a moat, it doesn’t matter as much. And I think that Coca-Cola could be an example of, of that, Preston.
Preston Pysh 19:14
Yeah! Well, and so when Stig says a “Moat,” what, what Buffet’s referring to as a moat, when you go back into like the medieval times and you had a castle. The way that they would defend the castle was they put a moat around the outside of the perimeter of the castle. Because anyone who was trying to come and conquer that castle, the moat provided more standoff range, so that whenever they’re shooting archery or things like that, it was difficult to attack that castle. So the wider the moat, the more difficult it was for somebody to come and attack you. And so when Buffett calls it a “Moat,” what he’s saying is, “Does this company have some type of defense mechanism to it to protect it from competitors?” So when you look at a company like Coca-Cola, well, its moat is the fact that it has an incredible brand. It has a secret ingredient or secret sauce to how it’s made. That is the moat, okay? And when you buy a business; when Buffett buys a business, he tries to find a business that has a large moat, so that it can protect itself from future competitors. So these are some of the quality aspects. Yeah. Go ahead, Stig!
Stig Brodersen 20:26
So for instance, if you need to, to continue about, speaking about moat. A company like Walmart, for instance. And I got to say, at the moment, Warren Buffett both owns stocks in Coca-Cola and Walmart. But if you look in a company like Walmart, they also have a wide moat. And the reason why they have a wide moat is because they have a very low cost. It is very, very hard to find another retailer in the world that has the same low cost structure as Walmart. Because how can they actually do that is really not impossible because Walmart combined so lots of quantities (*inaudible*). And even though if you can stand up as a retailer selling exactly the same thing as Walmart, you probably won’t have a chance to buy as cheap from your suppliers, so you won’t have a chance to sell this as cheaply as Walmart.
Preston Pysh 21:11
So in short, okay? You’re hearing different companies that Warren Buffett owns and the kind of his thought process and buying businesses with the shares that he purchases. And the thing that you got to really understand is that you’re not going to make a whole lot of money really fast. You’re not going to turn around and two years from now and be a millionaire. That’s just not gonna happen. That’s fine! It’s the approach. It’s making good solid picks time and time again, so that you don’t lose your principal. If you work really hard and you make $10,000, the last thing you want to do is lose that $10,000. And I think the thing that you’re really going to take away from this podcast is you’re going to feel enlightened. You’re gonna feel, you’re gonna sleep better at night because you’re gonna know what to do with your money, and you’re gonna be putting it into ownership of businesses that are safe, stable, sound businesses that have good returns, and they’re giving you a much higher return than you’d get in your savings account.
Stig Brodersen 22:07
I really come to think of a quote here, Preston. It’s a quote by Warren Buffett, and it goes like this, “Rule number one: Don’t lose money. Rule number two: Don’t forget rule number one.” I really love that quote.
Preston Pysh 22:21
Yeah. And, and you know that you couldn’t have concluded kind of what we’re talking about here in this first episode better than that. We’re gonna to try to help you protect your principal, and you’re going to make your return in the process. You’re not gonna become a millionaire next year by listening to this podcast, but what you will have is the principal and the money that you initially invested because you’re going to be making strong business decisions; and you’re going to be acquiring more and more equity; more and more shares of these businesses over time. And eventually, it’s going to become a weighing machine and not a voting machine. And you’re not going to be, you know, logging in to check your Scottrade account and trading day to day. You’re going to be just making decisions and checking it from time to time. And you’re going to continue to see your equity grow in each of these, you know, fantastic businesses that you would select.
Stig Brodersen 23:09
So, so, one question that is always really good to ask for making a business decision is, “Do I really want to own this stock if the stock market closed for like five years?” And if you can answer yes to that, then you probably have a very good business.
Preston Pysh 23:24
Yeah. Okay! So we’ll go ahead and conclude the first episode, kind of with that note. To hit the highlights, Warren Buffett, he buys businesses, big businesses, billion dollar businesses, the same way he buys small businesses on Main Street. He always starts off with what’s the value of this stock that I’m buying. And then he looks at what’s the market offering me on the price to purchase it. Always start with, “What do I think it’s worth,” and “What can I buy it for?” He treats one share exactly the same as owning all of the shares, okay? It makes no difference. It’s all proportional. It’s, it’s divided up, it’s like, eating one slice of pizza would be the same taste as the whole pizza itself. The taste doesn’t change. He’s trying to find a very high quality business with a low amount of debt. He’s trying to find something that’s stable and understandable. And we’ll go into a lot more depth and discussion on all this stuff as we go into future episodes, but those are the high points. So the one thing that I want to say as we kind of wrap things up is that if this podcast is helpful, we would really appreciate your help and your support. The best way to keep us motivated is to leave a review on iTunes. This way, we can continue to help you learn more things about Warren Buffett, Benjamin Graham, who is Buffett’s professor at Columbia, and countless others. You can also go to buffetsbooks.com, and you can watch some of the videos that Stig and I have created. Also, everything on this site, on the Buffets Book site is completely free, and it’s all video-based. So if you want to watch in and see how things move dynamically, and maybe it’d be more understandable for you, you can go to Buffets Books and check that out. If you’d like to be a guest on our show or you would like to advertise on our show, you can do that by going to theinvestorspodcast.com. Or you can go to asktheinvestors.com, and ask your questions. And we’re going to be able to play your questions. There’s a device there to record your question. We can play your question on the air, and if that happens, we’ll send you a free signed copy of Stig and I’s book, the Warren Buffett Accounting book, and we’ll send that in the mail to you. All you gotta do is just record your question or type up your question at asktheinvestors.com, and send that off to us. And we’ll play it on the show. All right, so we really appreciate you guys joining us for this first episode. We look forward to learning more and teaching more in the second episode, and we’ll see you then!
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