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LESSON SUMMARY
In lesson five, we learn that Warren Buffett applies four rules to invest in stocks. All the rules must be met in order for him to purchase shares of a company. Those four rules are the following:
- Rule 1: A stock must be stable and understandable
- Rule 2: A Stock must have long term prospects
- Rule 3: A Stock must be managed by vigilant leaders
- Rule 4: A Stock must be undervalued
Warren Buffett learned a basic valuation technique in his first investment job working for Benjamin Graham, using price to earnings (P/E) and price to book value (P/BV). While we learned about the P/E in lesson 4, P/BV is a new but very important key ratio to know.
The P/BV is a measure of the price you pay for $1 of the book value in the business. If you buy a stock with a P/BV of 14.3, it simple means that you pay $14.3 for every dollar you would get back if the stock was liquidated right now. As an investor, you would like to have as much book value for your dollar as possible since it’s a measure of your safety.
- High P/BV = Low safety (typically above 1.5)
- Low P/B = High safety (typically below 1.5)
The basic valuation technique that Warren Buffett is using is simply multiplying the price to earnings (P/E) with the price to book value (P/BV). If it is no higher than 22.5, it is a strong indication that the stock might be undervalued. The reason for this is that a low P/E is an indication of a high return, while a low P/B is an indication for high safety.
In this lesson, we also learn that Warren Buffett only looks at the stock market as a place to go for buying and selling stocks. While you could bag great deals sometimes, it could also be equally horrible at other times. This also means that Warren Buffett is under the impression that you should buy stocks as if the stock market is closed for 5 years. This approach also explains Warren Buffett’s view on patience. He does not believe in getting rich overnight because massive return is often accompanied with massive risk. The trick to stock investing is to have sound rules that you do not deviate from. Other investors’ actions might tempt you to break them; however, there is no replacement for thinking for yourself. The financial crisis where high quality stocks were trading at low prices is an example of this. By selling at a rapid pace, investors convinced other investors to sell their stocks, but smart investors made their own analysis and bought instead of selling.
LESSON TRANSCRIPT
This lesson is a quick and brief overview of the fundamentals of Warren Buffett. As you go throughout the website, there will be more information on everything contained in this short lesson.
Warren Buffett is a person who likes simple things – focusing on fundamentals and not getting into the weeds on certain things. He views things from a very simplistic viewpoint.
BUFFETT’S 4 RULES FOR BUYING STOCK
Warren Buffett has 4 rules for investing in stocks:
- Stocks have to be understandable.
- Stocks must have a long-term prospect.
- Stocks must be managed by diligent leaders.
- Never buy overvalued stocks.
First off, stocks have to be understandable. Most people are attracted to stocks because they have large rewards even though a lot of risks are associated with them. Warren Buffett is not attracted to such stocks because a stable and understandable stock is something he can actually calculate. When a company is producing the same earnings year in-year out and is growing consistently while producing 10% a year, Warren Buffett can predict that company’s worth next year and the following years. In simple words, never invest in a company without determining if it is stable and understandable.
Stocks must have a long-term prospect. Warren Buffett does not invest in a company that sells Televisions or DVDs. He looks at a company and says, “40 years from now, does the world still need this? He buys something that allows him to take a hold on it so that it grows without him having to pay any taxes on that growth. Stocks must be managed by diligent leaders. This is harder to assess as a small investor, but not as a large investor like Warren Buffett. The company has to be managed by individuals who manage debt well. Stay away from any company that has a lot of debt! Keep in mind to completely rule that out!
Never buy overvalued stocks. Warren Buffett determines the intrinsic value of a stock. If the stock is worth $50, he will bargain for an even lower price like $40. Always find the intrinsic value.
Buffett never goes out and says, “Well, rule 3 and rule 4 are met, so I’ll buy this company.” He ensures that all 4 rules are met. Similarly, you could do the same because it really works out well.
Here’s a quick look at rule 4 where stock must be undervalued. When Warren Buffett worked for Benjamin Graham, he had a quick way to find companies that were worth investing in. Buffett and Graham tied up all three terms together (market price, earnings, and book value) to assess a company.
THE WARREN BUFFETT VALUATION TECHNIQUE
When we look at Nancy’s ice cream stand from the previous lesson, we divided it into 10,000 shares with a market price of $10 per share to achieve the $100,000 she was asking for the business. The net income was $20,000, so her earnings are $2 per share. For the $7,000 in equity she had on her balance sheet, we divided that by $10,000 which created 70 cents in book value. These are important terms that we learned in the 4 lessons.
Buffett wraps all three terms into one quick assessment. We will look at the earnings that sell our potential returns and combine them with the book value for the assessment of your margin of safety. Start with the earnings. We talked about the price-to-earnings ratio and one of the previous lessons is to take the price and look at the earnings. The price is $10 and her profit is $2. See below:
Market Price $10
Earnings $2
Potential Returns
P/E = $10/$2 = 5
P/E = 5
Return = 20%
In the previous lesson, for the ratio, you say the same: “For every 5 dollars I spend buying this business, I can expect 1 dollar in return after a year.” When we see the P/E of $5, would that mean that the company could actually turn all those earnings into money that goes into your pocket? Find out in course 2.
Meanwhile, let’s assume all those earnings go into your pocket, thus giving you a 20$ return. To figure this out, take the $2 earnings divided by the market price, so that’s 20%. When you see that the P/E is equal to 25, it is actually giving you a 4% return assuming that the company can turn all the earnings into money. The best you can do is 4% and the P/E is 25. When you look at the P/E of 20, your return goes to a P/E of 5. Nancy gets down to the P/E of 5 for her business with a return of 20%, which is pretty high. When the P/E is really low and the return is high, you can expect the margin of safety to get worse.
Now, let’s discuss the price of the book value. This is a ratio that we haven’t looked at yet – the price to book value ratio. We are doing the same things that we did with the P/E ratio. Take the price ($10) and divide it by the book value to get the ratio. Now, take $10 and divide it by 70 cents to get a ratio of 14.3. What is a 14.3 ratio? A similar phrase that we said before, “Every $14.3 I spend buying this company, I will have $1 of equity in the business,” comes to mind but that’s not really good. Just like the P/E, the lower the number, the better for you, because you have more safety in your investment.
Market Price $10
Book Value $0.70
Price to Book Ratio
P/BV = $10/$.70 = 14.3
P/BV = 14.3
Every 14.3 dollars paid for this company is $1 book value.
Now, let us look at the price to book compared to the safety. If you had a company that had a price to book value of $5 on the ratio, it means that only 20% of what you’re buying in the company will be yours. For example, for a $100,000 business, only $20,000 will be the equity. If you bought it for $100,000 and you need to end it today, you’ll get $20,000. As we go down those numbers (see below), the safety changes. Just like what we learned, the earnings are meager when the price to book is low, but on the other hand, the price to book value is good when the earnings are good.
| P/BV = 5 | Safety = 20% |
| P/BV = 3 | Safety = 33% |
| P/BV = 2 | Safety = 50% |
| P/BV = 1.5 | Safety = 67% |
| P/BV = 1 | Safety = 100% |
| P/BV = .7 | Safety = 143% |
What do all these mean? While the earnings discussed here are the returns we will get, the book value talks about the safety of the investment. Back in those days when there was no internet, Buffett and Graham had big books with all the ratios and prices for all kinds of different stocks trading in the New York Stock Exchange. In order to determine whether he could pursue or ignore a company, Buffett would find the P/E and the book value. He would focus on a business with a P/E of 15 or lower. He was looking for a return of something better than 6.6% and later, he’d try to find a company that had a price to book that was lower than 1.5 because that’s where all the safety was.
Graham came up with a great idea of trying to find a company that had a P/E below 15 and a price to book below 1.5. He said, “Why don’t we just take these two numbers and multiply them together? If we do 15×1.5, that’s 22.5.” When he said, “I’m looking at this big book of all these ratios and terms, I can quickly assess whether a company is interesting by taking the P/E and multiplying it with the price to book. If the number comes out before 22.5, I want to take a look at it”. It incorporates all the variables that we’re concerned with.
What price would you buy this thing for? Will the return be good? How much safety is involved? All the terms are wrapped up in taking the P/E and multiplying it with the price of the book. Make sure the number is below 22.5. Buffett used to do this when he worked for Graham – go through big books and find companies below 22.5.
As we go further, you’ll get into course 2 and realize that the valuation gets a lot more complex than this simple model. If you want to try this with companies, you will discover that it gives you a really good fix for such a short and easy assessment. Again, just take the two ratios, multiply them together, and look for numbers below 22.5.
In order to help you determine that Buffett and Graham’s system really works, I did it myself with Nancy’s business. If you remember the P/E for Nancy, it was 5. Her price to book was 14.3, so 5×14.3=71.5. If we run Nancy’s business through Buffett’s valuation tool, she would have missed the mark by a lot. She was way overvalued!
BUFFETT ON THE MARKET, PATIENCE, AND INDIVIDUALITY
In course 1 unit 3, the focus is on understanding the market. Buffett always looks at the market as nothing more than something that can facilitate him in buying companies at a low price. His opinion on the market goes into rule number 4: stocks must be undervalued. He used it to his advantage as opposed to something he’s scared of.
Assume that the stock market could close tomorrow and not reopen for another year. When Buffett buys, he plans on holding on to the shares and getting connected to the company forever. He purchases stocks based on the assumption that buying the company will give him a 10-15% return by looking at what the company’s worth. When the company offers him a price much lower than what he thinks it is, he buys it. Someday you’ll get offers of good buys and some days for horrible buys. For bad deals, simply don’t take it!
Patience and individuality. According to Buffett, there’s no way you’ll become a successful trader unless you become patient and stick to your fundamentals. Pigs get fat and hogs get slaughtered. When a person tries to find a company that multiplies his money in three months, he won’t be successful for long. Be patient! Be happy with a 10-15% return on your money, and find yourself successful in the long run. Don’t ever base your stock investing offer on other people’s opinions because when you do that, you’ll be in trouble.
In 2000 and 2009, the market was really low. Everyone was just screaming bloody murder. The economy was collapsing. I bought companies with unbelievable values and had almost no debt which really paid off well. Whenever the stock market is good, everyone talks about what they buy. If you do everything that everyone else is doing, you’re doing something wrong. Get out and start getting more involved in the stock market and bonds. Conduct your own valuation on what you think things are worth and go to the market to see great value offers.
Again, Warren Buffett has four rules for investing in stocks that must be met before buying. We also learned a very basic valuation technique: multiply the P/E ratio by the P/BV ratio and the result needs to be lower than 22.5. The stock market is nothing more than a location where you can buy or sell shares. Buffett always buys on the assumption that the stock market could close tomorrow and not open for five years. Finally, we learned that Warren Buffett possesses great patience. He never tries to make enormous gains but receives consistent gains at reasonable levels. He always thinks for himself and always determines the value of a stock based on what HE thinks a company is worth – not the market.
LESSON VOCABULARY
P/BV ratio
This ratio represents the current market price divided by a company’s book value. This ratio is a comparison of what you might pay for a company compared to its value if the company liquidated (or terminated). A P/BV = 1 means that every dollar you spend purchasing the company also has 1 dollar of equity already in the business.
