Warren Buffett Investment Strategy
35 Free Video Lessons
Note: The lessons are taught in chronological order, so don’t skip any lessons.
LESSON 1: WHAT IS VALUE INVESTING
In this lesson, we learn about the fundamental approach Warren Buffett uses to invest his money. The method is called value investing and it’s based on the techniques Buffett learned from his college professor, Benjamin Graham. Graham was Buffett’s professor at Columbia Business School and very famous for writing the #1 selling investing book of all time, The Intelligent Investor. This lesson has the following important points.
1) Value Trading Versus Value Investing: When we talk about value trading, this is when a person buys an assets at a low price and expects to sell it at a higher price. This would apply to something like a commodity (like oil). When we think about value investing, we are not only buying an asset at a low price and expect it’s value to increase, but it also has a capacity to earn a consistent income. Assets (or securities) like Stocks and Bonds fit into this category. This concept is very important as you continue to learn more about determining the real value (or intrinsic value) of an asset.
2) Assets Versus Liabilities: Simply put an asset is something that’s going to continue to put money in your pocket, or it’s a safe store of buying power. A liability on the other hand is something that takes money out of your pocket over time. A liability is also a store of negative value for a business. For example, a loan would be listed a liability.
LESSON 2: HOW TO VALUE A SMALL BUSINESS
In this lesson, we learn the basics of how to value any small business. The small business in the video is an ice cream store, but all businesses – whether large or small – are basically structured the same way. Companies create value for the customer, and in return take that profit and send it back to the owner at the end of the year. This lesson has the following important points.
1) The difference between revenue and profit: When we think of how much money a business is making, we often think about the revenue and not the earnings. This is logical since it’s the amount of money we are handing over when we buy a good or a service. We rarely think about all the costs associated for the business including material, labor, rent, taxes etc. .
2) How much will you pay for profit: If there is one law that everyone in investing should be aware of, it’s that the higher you pay for a part in the company’s earning, the lower your expected return will be and vice versa. Therefore, you should always carefully consider as to how much you are willing to pay for your investment.
LESSON 3: MARGIN OF SAFETY AND BALANCE SHEETS
In this lesson, we look at the balance sheet of the company. Many investors tend to first look at the income statement since it states how much money the company is making. While this is also very important, the investors should also realize that he is not just buying a cash flow from the company, but also the assets that are producing it. This lesson has the following important points:
1) What is a Balance Sheet: The easiest way to think about a balance sheet is to consider what would happen if the ice cream business would liquidate right now. Imagine that the asset value of the ice cream stand is $10,000, and the debt used to finance the machine is $9,000. The remaining is $1,000, which is called the equity. It’s actually that simple. A balance sheet tells you how much the company owns, how much it owes in debt, and how much the owner would get if the company was liquidated.
2) What is Margin of Safety: This is a very important concept for value investors to understand when evaluating how much they are paying for a business. On one hand in your valuation, you don’t want to pay too much for $1 profit. But on the other hand, you don’t want to pay too much for $1 asset either. The less you pay for an asset, the wider your margin of safety is.
LESSON 4: WHAT IS A SHARE OF STOCK
In this lesson, we learn that a share is a part of a real business. In other words, if a business has 100 shares and you own 1 share, you own 1% of the business. This is no different than owning 1% of the ice cream stand and 1% of the machine. On the flip side, it also means that you are paying for 1% of the employee’s salary. This lesson has the following important points:
1) Value a Business versus a Single Share: When we deal with very large numbers when evaluating a large company, it can be hard to estimate if we’re buying it at a good price. The trick here is to think about the business on a per share basis, as there is no difference between valuing a single share or the entire company.
2) What is a P/E ratio?: Simply put, this is the same as asking the question: How much would you pay for a share that is making $1? You find the P/E of a stock by dividing the stock price and the earnings. So if the stock costs $20, and is making $1, the P/E is simply 20/1 = 20. You want to buy stocks with P/E that is as low as possible.
LESSON 5: WARREN BUFFETT INVESTING BASICS
In this lesson, we are first introduced to the rules billionaire Warren Buffett uses to pick stocks. These rules will be examined in detail in lesson 17-21. However, to understand the very basic of this, we need to first learn a quick valuation tool to filter through potential stock picks. If the P/E multiplied with P/B is below 22.5 it might be worth to take a closer look at the stock. This lesson further discusses the following important points:
1) What is Price to Book Value (P/BV): P/B is the price you are paying for the book value of an asset. Imagine that the company has bought an asset for $10,000 and that it includes all the assets there is in the business. Therefore, if the business costs $15,000, you would be paying a P/B for 1.5.
2) Never Break Your Rules: As a stock investor it’s easy to be influenced by all the noise that always surrounds investing. You constantly hear news and opinions from other so called experts and that can alter your own strategy. First and foremost, the individual stock investor must think independently and set up his/her own rules and should try not to break them. That will also relieve you from a lot of stress.
LESSON 6: WHAT IS A BOND
In this lesson, we learn that a bond is nothing different than a loan. As an issuer of a bond, you are effectively borrowing money from the investor at a given price. That price is called the interest rate. The higher the interest rate, the more expensive it is for the issuer to borrow money, and the higher the return is for the investor. However, the higher interest rate is typically associated with a higher risk since a bond is worthless if the issuers can uphold its payment obligations. This lesson also teaches you the following important points:
1) Why Issue a Bond?: Bond issuers are usually either big companies, municipalities or the government. With help from an intermediate like a bond, they can finance different investments. The benefit of issuing a bond compared to issuing equity is simply that the shareholders do not give up any control.
2) Why would I invest in a bond?: Bonds are typically preferred by investors because it gives them a stable income. If you buy a stock at 6% for $100, you can be sure of receiving $6 every year as long as the issuing of the bond is operating. The stability of that cash flow is a nice supplement to the stock investor who always operates in a volatile environment.
LESSON 7: THE COMPONENTS OF A BOND
In this lesson, we learn bond terminology. While this might seem complicated on first glance, it’s easiest to think about the terminology as what describes the conditions in which a loan is obtained. You are paying an interest rate, which, in bond terminology, is called a coupon. If you were to loan money to someone else, what type of information would you require aside from the coupon? This lesson teaches you the following terminology:
1) What is the Face Value of a Bond: The face value of a bond, which is also called the “par value”, is the amount of money you get when the bond has matured. In other words, if you have a face value of a bond of $1,000, as an investor you would receive exactly that amount when the bond, which is essentially a loan, has expired.
2) What is the Term of a Bond: The term simply states when the bond is issued and when it matures. This is no different than if you take a 30 year loan to finance your home. Then the documents will also state when you have paid down the principal of the loan. As the investor, you would continue to receive coupons until the end of the term.
LESSON 8: BOND VALUE AND YIELD TO MATURITY (YTM)
In this lesson, we will expand the simple framework we know about collecting coupon payment from bonds. In the simple version, we learned that if we buy a bond for $1,000 with a 5% interest rate, we receive $50 every year as a bond investor. In this video, we will expand the example to understand what happens if the investor does not buy the bond at face value. This lesson teaches you the following points:
1) What is the current yield? : If you pay less – say $800 – than the face value of a $1,000 bond with 5% coupon rate, your current yield will be higher than 5%. Why? Because you are not getting a 5% return on the $800 you are initially investing, but on the $1,000 which is the face value.
2) What is Yield to Maturity: The yield to maturity tells you the total return you can expect to get from the bond. This includes the current yield, and it also includes the difference from the price you paid for the bond to the face value. Let’s assume that you have paid $800 on a bond with face value of $1,000. In this case, the yield to maturity also covers the extra $200 you gain from buying the bond at a discount.
LESSON 9: THE STOCK MARKET
In this lesson, we learn the basics of the stock market. The easiest way to think about the stock market is to think that it’s like a market where people trade a share or business for money with other people. If we didn’t have a stock market, people would still be able to trade part of businesses, but it would be more complicated. You would have to match a buyer with a seller, and you would incur a lot of transactions costs while setting up every single deal. The stock market does all that for you. The buyer doesn’t even have to know each other, and a deal can be struck in less than a second. This lesson also teaches you the following points:
1) How Does the Stock Market Work: If you own a piece of a business, you can sell your share in the stock market. When a buyer and a seller agree on a price, the ownership of the stock is transferred and the money is going in the other direction. When you see that there are many sellers for a particular stock, the stock price will gradually decline, but it’s important to remember that there is always a buyer and a seller in each trade. If fewer people were interested in buying, the price would simply decline down to the best bidding price.
2) Who is Mr. Market: Benjamin Graham, Warren Buffett’s professor at Columbia, first introduced the fictitious character Mr. Market. Mr. Market is his metaphor for the mood of the stock market. When the market’s in a good mood and high in spirit, the prices soar. You can also advantage of that by selling your stock; however, when he is in a sour mood, the prices plummet; thereby letting you take advantage and buy at discounted prices. Graham taught Buffett that he should always remember that Mr. Market should be your servant and not your guide.
LESSON 10: STOCK MARKET CRASHES AND PSYCHOLOGY
In this lesson, we learn about the psychology of the stock market. The prices of stocks in the short run are based on emotions of the participants. Who are the participants in the stock market? It’s basically everyone who is trading stocks. The one thing all participants have in common is that they’re all humans, and all humans have the emotions of being greedy and fearful. For you, as a stock investor, this has two very different implications that we will learn about in this video:
1) The market behaves differently in the short and the long run: What this means is that in the short run, the price and the value of the stock can be very different. If people are greedy, a stock can be priced very expensive and might lead to a bubble, but if people are fearful the stocks can be priced very cheap, which is the time you want to invest. In the long run, however, the price and the value of the stock will converge. This will reward shrewd investors who bought cheap and sold expensive, and punish the impatient investor that did the opposite.
2) Accumulating stocks vs. Trading Stocks: The right way to invest in stocks is to calculate the intrinsic value of the share and accumulate shares when the price is cheap. This approach is value based and is rooted in patience. Many investors, on the other hand, tend to look at stock investing in terms of trading shares. In other words, these investors looks at the price of the stock as the indicator of the performance of the company, and think that it’s best to buy more when the price has gone up.
LESSON 11: WHAT IS THE FED
The purpose of the FED is to control and stabilize the economy. One of the most important tools to do that is by adjusting the interest rate. When the FED lowers the interest rate, it gives the population an incentive to spend more money and for companies to borrow to invest in new equipment, thereby stimulating the economic activity. The reason for this is that it’s cheaper to borrow money. The lesson further teaches the following points:
1) How does the FED Stabilize the Economy and the stock market: If the economy is in a greed cycle where everyone is buying stocks, the FED can raise the interest rate. When it does that, it given investors an incentive to buy bonds contrarily to stocks which can counteract a bubble. If the economy is in a fear cycle, it will do the opposite and encourage people to spend more money on everything, including stocks.
2) Do you want to own stocks or bonds: The rule of thumb here is really simple. When the interest rate is low, you want to be involved in stocks, and when the interest rate is high you’ll typically favor bonds. To figure out exactly which asset class is optimal, you need to compare the expected returns on the asset classes.
LESSON 11.1: LARGER MARKET CYCLES
This lesson was created by billionaire Ray Dalio. His net worth is $16 billion USD and he is the founder of the world’s largest hedge fund. In his video, you’ll learn that the economy is simply the aggregated sum of all transactions. The transactions are heavily dependent on credit, since more credit will create more economic activity and grow the economy, in the short run at least. Once you understand how credit works, you’ll understand the most overlooked and misinterpreted concept in larger market cycles. This lesson has the following points:
1) Why do we have cycles in the economy: The premises to understand the economy is to understand that one man’s spending are another man’s income. The natural implication of this is that the more we spend, the more the society earns. We can spend both the money that we have and money that we don’t have (credit) which will spur economic growth and a positive cycle. At some point of time, money has to be repaid, and we can now spend even less than our income. This is a negative cycle. Cycles simply comes from credit.
2) Is Credit Bad: It would be logical to assume that credit is bad, since a world with no credit won’t have cycles. However, credit is also a good thing. It’s good when it’s used to make investments that grow employment and in turn the economy. It’s bad when it’s used to buy useless things that don’t create income to repay your debt.
LESSON 12: FINANCIAL RISKS
In this lesson, we will be looking at the top three financial risks. The top risk is debt. For a company, debt is like going faster in a car. If the road is smooth, you will get to your destination really fast, but if the road has curves you are likely heading for trouble. This lesson also includes the following points:
1) Why is it risky to overpay for an investment: The way Warren Buffett looks at the price of an investment is by saying, “The price is what you pay – value is what you get.” The intuition is very simple. All assets have a price and a value. If you pay more than the value of the asset, you are left with a small return. If you, on the other hand, buy at a price below the value, you can expect to grow your investment a lot faster. While the main financial risk is to lose money, having the opportunity to build wealth but doing it at a much slower pace is likewise risky.
2) Risk comes from not knowing what you are doing: Warren Buffett’s primary rule is to fully understand what he invests in. For instance, when you buy a car or even a home, you tend to do it after you completely comprehend what it’s worth and why it has the value that it does. When it comes to stocks, some people invest even when their knowledge is typically not as developed. This creates a new risk because not only do they now know what the value is, they also don’t know understand when the value changes, or why the price might change too.
LESSON 13: WHAT IS INFLATION
When there is inflation in a country, it simply means that you can now buy less goods and services for the same amount of dollars. In other words, you can’t get the same item for $1 today as you could 10 years ago, and even less than what you could buy 50 years ago. Inflation occurs when the central banks are printing more money and thereby dilute the value of the existing dollars. This lesson has the following points:
1) Why does the government inflate their currency: You might have heard the government say that they aim for a specific target of inflation dependent on the current market conditions. While that might often be true, there is another reason why you can always expect government to want some kind of inflation. The reason is taxation. You are taxed on the nominal amount of your income and your asset. For instance, if you have a stock that is priced at $100 and the inflation is 2%, the price next year everything else equal is $102. That capital gain of $2 is taxable for you when you sell your security.
2) How does inflation impact bonds and stocks: Since bonds are fixed income assets, inflation has a drastic impact on the real return you can expect. While you might get a nominal 5% return, you need to subtract the inflation to find the real return. The real return is the gain in your purchasing power. Assuming that the inflation is 2%, you have a real return or the extra purchasing power increase of 3%. For stocks, the situation is different. Inflation will grow the earnings, though artificially, and the price of the stock will follow the inflation. The drawback for stocks is therefore less than bonds; however, the inflated capital gain or dividend still has to be paid taxes on.
LESSON 14: THE S&P RATING
As a bond investor, you are not only looking at the potential return you can get in terms of the coupon rate. The return is also heavily determined by the risk of the company defaulting, in which you don’t get any future payments. This lesson will tell you about the credit rating agencies that can assist you in the process. The lesson also includes the following points:
1) Who are the major credit rating businesses agencies: Standard & Poor, Moody’s, and Fitch are called the “Big Three”. When investors look at the quality of debt for companies, the easiest way is to look up the credit rating from one of the big agencies and use that as an indicator.
2) What characterizes a good credit rating: The Big Three has somewhat of the same system when they rate company bonds. The notation is slightly different but if you see something called “Aaa” or “AAA” it’s a strong indicator that the risk of the company to default is very slim.
LESSON 15: WHAT IS A YIELD CURVE
When it comes to stock and bond investing, everyone wants to know where the markets are heading. Clearly this is very difficult, but one thing that might give us an indication is the shape of the yield curve. Remember that the yield is the return you can expect to get from a bond. This lesson also includes the following points:
1) What is a yield curve: The yield curve graphs what type of return we can expect to get dependent on the term of a bond. For instance, if the yield curve is upward sloping it may indicate that we can expect a 5% return for a 30 year bond and a 3% return for a 5 year bond.
2) Can the yield curve predict the future market for stocks: While it’s not an indicator that is 100% accurate, the yield curve is mirroring how the FED looks at the current market conditions. For instance, if the yield curve is upward sloping, then it indicates that the FED wants you to spend your money right now, since you would otherwise only get a small return in the short run. More spending leads to a booming economy and higher stock prices. If the yield curve is flat or inverse it might rather indicate that the economy is booming and the FED wants you to slow down since you’ll get a nice return by investing in short term bonds.
LESSON 16: FIND THE VALUE OF A BOND
In this lesson we learn how to calculate the value of a bond. The value of a bond is partly determined by the coupon, which is the money you get from holding the bond, and partly the term which defines for how long you can hold the bond. Further, the value is determined by the face value which is the amount of money you receive by the end of the term, and last but not the least, by the interest rate. This lesson has the following points:
1) What is the relationship between interest rates and the value of bond: The easiest way to think about interest rates when you buy a newly issued bond is to assume that the coupon rate is the same as the interest rate. Imagine that the interest rate is 5%, so you expect to get 5% coupon. Now assume that interest rate declines to 4% on the day after you buy the bond. What does that do to the value of your bond? It increases! This is very intuitive. You get 5% while all new investors can only expect to get 4% return on their investment.
2) What is the relationship between the interest rate, the term and the value of the bond: The concept that interest rates and bond prices always go in each direction is also valid when you account for the term. The remaining period of the term rather determines the magnitude of the change in the bond price. The reason is simple. If you get 5% on your bond and everyone only gets 4% it’s more valuable if you can hold that bond for 20 years than only 1 year.
LESSON 17: WARREN BUFFETT’S 4 RULES
This very short lesson outlines the 4 rules that Warren Buffett uses when he selects stocks. The video emphasizes the following points that all rules with no exception have to be met. The rules are:
- A stock must be managed by vigilant leaders
- A stock must have long term prospects
- A stock must be stable and understandable
- A stock must be undervalued
LESSON 18: RULE 1 – LEADERSHIP
In this lesson we learn that a vigilant leader is always on the lookout for danger. We learn that the leader of the company is only an agent for you. As the shareholder you should consider yourself as the owner of the company, and always expect that the management is taking care of your interest. As an owner, you should look for two very important indicators that show how the management is handling the debt and cash flow. This lesson includes teaches you the following points:
1) Debt to Equity ratio <0.5 : The equity of a company can be seen as what the company owns when all debt is subtracted. After this, look at the total debt that the company has borrowed and compare the two. To feel comfortable as an investor and use the same rules as Warren Buffett, you want to find companies that have a debt to equity ratio below 0.5. In other words you want the company to own twice as much as it owes.
2) Current ratio > 1.5 : The current ratio measures how much cash the company expects to have the next 12 months compared to how much cash that is leaving the business. A company can actually grow and be profitable with a current ratio below 1 in the short run, but sooner or later all companies need cash to survive. To be sure of the longevity of a stock pick, Warren Buffett prefers a current ratio above 1.5. In other words, he wants the company to have at least 1.5 times of the cash flowing into the company as expected to flow out.
LESSON 19: RULE 2 – LONG TERM PROSPECTS
In this lesson, we learn that Warren Buffett likes to invest with long term-prospects that he identifies by asking if the property of the product is subject to change. If we look at candy for example, it’s highly unlikely that we would consume candy differently or that the product will dramatically change. Compare that to an iPhone. Though it’s a great product, it’s equally highly unlikely that we will consume information and communicate the same way in 30 years. Warren Buffett wants a company with long term prospects that can continue to make a profit in the long run. Aside from the obvious notion that it’s nice for a company to generate profit, the additional reason is capital gains tax. In this lesson, we further learn the following points:
1) What is capital gains tax: If you buy a stock at $10 and sell it for $12, you are taxed on that $2 gain. In investing as with your personal life the biggest expense is typically what you incur and you want to pay as little as possible. If you incur the capital gains tax by selling your stock within one year, you are taxed heavier than if you hold it longer.
2) How to defer capital gains tax: The way to defer capital gains tax is actually quite simple: Don’t sell your stock! This underlines the importance of understanding the next level of Warren Buffett’s second rule. If the company has long term perspectives you’ll find that the stock continuously increases in value and you can defer taxes into infinity. Even if you eventually decide to sell, you’ll find that even at the same tax rate, it’s pays off to defer it as long as possible.
LESSON 20: RULE 3 – STABILITY
In this lesson we learn that Warren Buffett wants to invest in companies that are both stable and understandable. You can get a very good indication of this by looking at the key ratios for the previous 10 years for the company. This video shows you how and where you can find them, and also includes the following points:
1) Why is stability important for a stock pick: Warren Buffett always does a valuation before he buys a stock. It’s really hard to do a valid valuation if you don’t know where the business is tomorrow, and how much money it can expect to be making. Therefore he always makes sure only to buy into stable companies with proven track records.
2) Why is it important to understand the business model of your stock pick: You might be wondering how many things we use in our daily life and not fully understand. Do you really understand how a car works? No, not really, right? But you still drive to work every day. The reason why Warren Buffet wants to have detailed information about how a business makes money is because he can either add or eliminate his position in a stock. He makes that decision based on how he thinks the business is performing and where it’s heading, and he can only know this if he fully understands the business.
LESSON 21: RULE 4 – INTRINSIC VALUE
This lesson shows the last of the four rules Warren Buffett always applies when considering a stock pick. It’s the most complicated, and the rule that you should look at only if the three previous rules are all met. Before buying a stock, you should always compare the current stock price with your estimation of the intrinsic value. You only want to buy stocks that you can find at a decent discount. This lesson also includes the following points.
1) How can we calculate the intrinsic value of a stock: The intuition behind stock investing is very simple. You put up an upfront payment to get a share of the company, in the hope that it will increase in value. The value of that single stock is in directly proportional to the discounted cash that you can expect to be taken out of the business in its remaining life. Remember a stock doesn’t have an expiration date!
2) Why is the federal note used as discount rate: The reason why we even discount cash in the first place is because cash changes value dependent on time. Everyone would rather have $100 today than in a year because you can either spend it and get more goods than in a year, or invest it and grow it to more than $100. Warren Buffett has said that he uses the federal note as a discount rate, because he knows that this is a risk free return. This should be seen as opposed to stock where the returns are always uncertain. In other words: If the risk free return – the interest on the federal note – is high, the value of the stocks gets lower, and vice versa.
LESSON 22: PREFERRED STOCK
In this lesson, we learn that a preferred share is similar to a bond in the sense that you get a coupon. Where it is different is that the coupon is slightly higher, and that the management can choose to defer your coupon payment. The easiest way to understand a preferred share is to first fully understand the terminology for bonds that you can find in lesson 6-8. The reason that a company issues preferred stocks is the same as for bonds and stocks, namely to raise capital. The lesson also answers the following questions:
1) What is the difference between a stock and a preferred stock: You will often hear that a preferred share is more secure than owning a bond. The extra safety you gain from standing in line before the stock holders if the company is liquidated is very little. Usually bond holders take everything there is if the assets of the company are distributed. Another difference between conventional stock and preferred stock is that you don’t get the upside if the company performs very well.
2) Why should you read the certification of designation: The certificate tells you all the details of the preferred stock and you should never buy a preferred share without reading it in detail. One of the most important things to look for is if the stock is cumulative preferred or non-cumulative. You should only invest in the former since the company would be required to eventually pay out your dividend if the management decides to delay it.
LESSON 23: PREFERRED STOCK VALUATION AND YIELD TO CALL
In this lesson, you learn how to value a preferred stock. The final metric you are looking for after doing the calculation of the value is called the “yield to maturity”. This is really just a fancy way of saying: What return can I expect to get from the preferred share assuming that the company that has issued it doesn’t go bankrupt? The lesson also answers the following questions:
1) Where is the best place to conduct research about a stock: The best site is the free site Quantum Online. It provides you with a simple overview of the coupon rate, call price and all other relevant information about preferred stock you can think of.
2) Why is the call date important: Just like a bond, many preferred stocks have a given term when it expires; however, it’s not uncommon that you will find a preferred stock that doesn’t have a call date. What this means is that the management in theory can defer the payment indefinitely. While this is a drawback, it’s not plausible that the company wants to do so, since it can’t pay out dividend to the common stock holders in the meantime.
LESSON 24: PREFERRED STOCK BOOK VALUE
This lesson teaches you how to account for preferred shares on the balance sheet. As preferred shares are another form of raising equity, the combination of common stock and preferred stock can distort the book value and thereby also your valuation and your assessment of the stability for the overall company. This video also answers the following questions:
1) How can you calculate the book value for your stock if it has issued preferred stock: As with the book value calculation for common stock, you should start your calculation with the equity. The next step is to look up the company’s 10Q and locate how much preferred stock the company has listed. By simply deducting the amount from the total equity, you find the company’s book value.
2) Where you do find the company’s 10Q: Any major financial information providers like Morningstar, Yahoo Finance, and MSN Money, has direct access to all listed companies 10Qs and other financial filings. It is required by the SEC that all listed companies provide detailed information of anything that is relevant financially to the potential stock holders, and therefore you can always retrieve the information for free.
LESSON 25: INCOME INVESTING
In this lesson we learn that Income Investing is a neat way of investing if you are planning your retirement. The simple concept is that you should acquire enough stocks and bonds to live off the income from future dividend payment and coupons. This lesson also answers the following questions:
1) How much should you have to plan for your retirement: A rule of thumb is that you should multiply the annual income you expect you can live off with 20-25.. If you expect to live comfortable for $50,000 a year, you should be prepared to set aside $1,000,000-1,250,000 before starting income investing. If you can make a consistent annual return of 4-5% you can maintain your principal.
2) What stocks should you choose: It’s not sufficient to only look at the current dividend payment and pick the best current returns when selecting stock. One key metric you should always have in mind in the company’s debt. If the debt is high, there is a high risk that the company will stop dividend payment if it eventually runs into problems. Another benefit of a well-run company with solid dividend stocks is that it increases the likelihood of compounding your monthly income from investing in lockstep with the performance. A rule of thumb is to find businesses that pay you 1/3 in dividend and reinvest 2/3 back into the business from which the company can grow.
LESSON 26: THE CASH FLOW STATEMENT
In this video, we learn that cash flow statement is an additional statement that provides you with information that the income statement and the balance sheet don’t. Whenever a business is conducting a transaction, whether it is selling a good or acquiring a new piece of equipment, it’s logical to assume that all transactions are settled in cash. However, in reality it’s not the case. The cash flow statement tells the investor how the cash flows in and out of the business, thereby giving you a very accurate picture of the health of the business, and makes the business more transparent for the investor. This lesson also answers the following questions:
1) What are the components of the cash flow statement: The cash flow statement consists of 3 major parts: “Operating, investing and financing activities”. As an investor, you should always take a close look at cash from the operating activities. This is the cash the company generates from the core business. The operating activities capture the investments the company is making, while the financing activities measure how cash from debt, equity, and dividend payments flows in and out of the business.
2) What components of the cash flow statement should generate cash, and what components should rather spend cash: Intuitively, it would make sense that a business should generate as much cash as possible right? Unfortunately, it’s not that simple. The quality of cash is very dependent on where it’s from. As operating activities measure the cash the company makes from the core business, you want this number to be as high as possible. This is in contrast to the investing activities, which should be negative. If you spend cash on investments, it implies that the business is growing, while the opposite might imply that the company is selling off assets, which might be good for the cash holding in the short run, but bad for business in the long run. Finally you want financing activities to be negative. A positive number implies new debt and issuing new shares that dilute your ownership of the company.
LESSON 27: CASH FLOW STATEMENTS (PART II)
In this lesson, we learn how to read a cash flow statement by comparing the statements from four different companies: Walmart, Sears, Intel, and Kodak. This lesson also answers the following questions:
1) Why should you look for trends in the cash flow statements: We already learned which sign we want to see in front of the components of the cash flow statement. When we look deeper into the cash flow statement, we should pay close attention to the trend of the operating, investing and financial activities respectively as cash flow statement in a single year can easily be distorted, but over the long run, it gives an accurate picture of the health on the company.
2) How is the cash flow statement related to the income statement: Your very starting point of the cash flow statement is the profit of the company. From that starting point, different items are taken into account. For instance, if you buy a car in cash, only a part cost of the car is recognized in the income statement, but you can see the actual cash outlay in the cash flow statement. There are no statements that are superior to the other, but you should rather think of the cash flow statement as a measure to validate the income statement.
LESSON 28: WHEN TO SELL STOCK
In this lesson you learn that the decision to sell your stock is not as tricky as many people will think. Firstly, the situation doesn’t occur on a daily basis, because Warren Buffett always aim to hold a new stock forever, and when they occur, it’s because he is only selling stocks when either of the following two conditions are met:
1) When you can get a higher return on another asset: To fully understand this condition, one must consider that stock investing is a game of opportunity cost. That simply means that if you invest $100 in one stock, you can’t invest the same $100 simultaneously in another asset. As a stock investor, you should therefore be ready to change position to another stock, if you think that the intrinsic value of your current pick is expected to grow at a very low rate, and you can find a better alternative. Remember that before you change your position, you should always consider potential capital gains tax and a solid margin of safety.
2) When the company fundamentally changes out of your favor: Back at lesson 17-21, we learned about Warren Buffett’s four rules that should always be met before he buys a stock. The same rules apply when he considers whether to sell a stock. For example, if he originally bought a business with vigilant leaders that managed its debt wisely, and Warren Buffett observes that this has recently changed, it’s a good reason to sell his stock.
LESSON 29: RETURN ON EQUITY (ROE)
In this lesson, we learn about Return on Equity (ROE) which is one of the most important key ratios to understand the value of the company. It gives you a very quick glimpse of whether or not you should invest in that stock pick. The lesson answers the following two questions:
1) Why is ROE one of Warren Buffett favorite key ratios: You can think of equity as the amount the company owns after it has paid all of its debt, and what the shareholders therefore fully own. ROE is especially interesting because it measures the return the capital is making, which is essentially the whole idea of stock investing. Keep in mind though that an ROE, of say 20%, doesn’t mean that your stock by definition will grow by 20% in price. This is partly because you typically pay a premium to the equity value of the company, but also because a high ROE is hard to sustain.
2) How do you interpret the trend of ROE: A profitable company has two choices to dispose the earnings. Either it can pay some or all of the profit out to the shareholders, or it can reinvest the earnings, which the majority of businesses do. While that is sometimes the most optimal option, very often the new investments don’t give the same returns as the current, which is typically chosen because they are most lucrative. This is reflected in a declining ROE, which all stock investors should avoid. A steady or even increasing ROE indicates a skilled management that pays of excess cash to the owners, and only invest in the best alternatives.
LESSON 30: WHAT IS STOCK VOLUME
In this lesson, we’ll look at the stock volume of a stock and learn where we can find it online. Stock volume is one of the most overlooked measures in stock investing as it doesn’t appear to be moving in either price or value of the stock. However, what we learn is that by putting the stock volume into perspective, shrewd investors can take advantage of this strong indicator in very high or very low markets. This lesson also answers the following questions:
1) How many people determine the price of a stock: Most investors would be surprised to realize that it’s relatively few people who determine the current stock price. The stock price is basically only the price the stock was traded at the last time, which could be between two individual investors. Even if you take the whole trading volume for a day, it might still be between 1-2% of all the shares.
2) How can you profit from a high stock volume: A relatively high volume in relation to the past is a strong indication that something is about to turn either dramatically up or down – dependent or the market conditions it should be fairly easy to see in which direction. In the event of a stock that is trading really low, you would likely observe that many sellers and only a few strong buyers, like Warren Buffett, purchase as many stocks as possible.
LESSON 31: CALCULATING STOCK TERMS
In this lesson, we learn how to calculate various stock terms that have been used throughout these video courses. As you start to dig into the finer art of stock investing, it’s recommended that you get yourself acquainted with the stock investing terminology. This lesson also teaches you the distinction between some of the terms that appear very similar including:
1) The difference between EPS and diluted EPS: One the most important key ratios are Earnings Per Share (EPS), which is typically the number that you find on financial information sites. One thing that investors should keep in mind is to check if there’s a large discrepancy between the reported earnings and the diluted EPS. Many listed companies give away stocks benefits to key employees. The company doesn’t go into the open market and purchase them, but rather they that annotate that on record. The end result however is the same – it has diluted the value for the current shareholders.
2) The difference between the divided rate and the dividend yield: Sometimes you’ll hear in the financial media that a company has decided to pay out $0.3 in quarterly dividend. This is the dividend rate that is referring too. However, often, the most interesting is the dividend yield. The yield indicates your dividend return in percent if you bought the stock at the current price.
LESSON 32: HOW TO USE A STOCK SCREENER
In this lesson, we learn how to use Google’s free stock screener. A stock screener is a very fast way to filter 10,000s of stock to a reasonable sample size you can analyze closer. We learn that by typing in a few simple criteria, the screener generates a list of stocks that fits your individual investment style. This video also answers the following questions:
1) What is the difference between qualitative and quantitative analysis: The quantitative stock screener only tells you one side of the story. However, to find the very best stock picks, you need to analyze the quantitative aspects of the business like competition, core competences, and growth opportunities. By applying a stock screener that gives you 10-20 stock picks, you can find potential candidates qualifying for a qualitative study.
2) Why should you change your quantitative criteria: Market conditions constantly change and with that, your quantitative criteria should do so too. That doesn’t mean that if stocks generally are very expensive, you should simply change your investment strategy and buy overpriced stocks. Instead, it means that if a given stock or a sector is really cheap, you can decide to be very picky.
LESSON 33: GOODWILL AND BALANCE SHEETS
In this lesson, we learn about goodwill. Goodwill is an intangible asset and can therefore be hard to relate to. A tangible asset could be a car or a building, which you can stand next to and touch. An intangible asset could be something like a patent, which clearly has value, but you can’t touch. Goodwill is also an intangible asset, and will be explained in this lesson including the following questions:
1) How does goodwill occur: Goodwill occurs when an acquiring company buys another company at a price above its equity value. If Apple were to buy any company for $50,000 and the target company only had $20,000 in equity, it would have to record $30,000 as goodwill on its balance sheet.
2) Why would anyone pay more than the equity value for a company: It might seem illogical as to why anyone would pay more than the net asset value of a company; however, the explanation is often very simple. When you are buying another company, you are not doing this to accumulate assets, but you are actually doing it to accumulate the earnings you can expect to receive from those assets.
LESSON 34: OWNER’S EARNINGS
This lesson teaches us about what owner’s earnings (sometimes called Free Cash Flow) are, and why Warren Buffett puts so much emphasis on that. Basically, Warren Buffett doesn’t think the most important metric is the reported earnings. He knows that for him as an owner, he should look at the amount of these earnings he is getting now, and more importantly how much he can expect to receive in the future. This lesson answers the following questions:
1) What impact does capital expenditures have on the owner’s earnings? : Capital expenditures are direct costs that you as the shareholder pay to maintain the business. Industries that require a lot of assets like the utilities industry can be very costly to operate in since the assets eventually needs to be replaced.
2) What is the most optimal business to operate in: All investors want to find profitable businesses and Warren Buffett is no different. The very best thing to find is profitable businesses that require very few resources to run. An example could be Coca-Cola because when compared to its size, it has few net tangible assets, and very valuable intangible assets like the recipe for Coke and customer loyalty. These intangible assets don’t have to replaced, and the earnings can all flow back to the owners.
LESSON 35: INTRINSIC VALUE USING DISCOUNT CASH FLOW (DCF)
In this lesson, we learn how to use a complementary calculator to the intrinsic value calculator introduced in lesson 21. Using owner’s earning, the DCF calculator is valuing the whole business compared to a single share basis, and it calculates the value based on perpetuity basis rather than 10 years.
1. When should you use the DCF calculator: Compared to the intrinsic value calculator, the DCF calculator is better suited for a high growth company. Since no company can sustain a high growth forever, this calculator can account for a high growth in the short run, and a more modest growth in the long run. Many listed companies also send earnings back to the current shareholders in terms of buying back shares. The DCF calculator is designed to take that into account, just as stock splits don’t cause any problems in the valuation process.
2. What is the limitation to the DCF calculator: The DCF calculator has the same shortcomings as any other valuation tool. It’s 100% dependent on the quality of the assumptions you have for the stock. If you are unsure of the validity of your projections, it’s always recommended that you are very conservative, just as it is preferred that even a conservative estimate of the intrinsic value is considerably higher than the current stock price.