5. Warren Buffett Stock Basics

welcome to course 1 unit 1 lesson 5 Warren Buffett stock basics in this lesson we have 4 lesson objectives the first lesson objective is to learn Warren Buffett's four rules for buying stocks the second objective is basic Warren Buffett valuation techniques the third lesson objective is Warren Buffett's opinion on the market and the fourth lesson objective is understanding Buffett's opinion on patience and individuality so let's get started ok so this lesson is just a quick and brief overview of the fundamentals of Warren Buffett now as you go throughout the rest of the website you're going to get a lot more information on all the stuff that you're that's contained in this short lesson so what I'm going to start off with is saying that Warren Buffett is a person who likes simple things he likes to focus on fundamentals he doesn't like to get down in the weeds on certain things he likes to look at things from a very simplistic viewpoint and so he has four rules that he uses for investing in stocks so the first rule is that the stock has to be stable and understandable for a lot of people they're kind of attracted to a stock that might be volatile because it might have huge rewards in the end even though there's a lot of risk associated with it and the reason Warren Buffett isn't attracted to his stock like that is because he knows that a stable and understandable stock is something that he can actually calculate so when the company is producing the same earnings year in and year out and they consistently grow their equity at 10% a year or whatever the case might be he can predict what that company is going to be worth next year the year after that and so one of his four rules that he absolutely sticks to is that he never invests in a company that he doesn't determine that is stable and something that he can understand so the second rule is that a stock must have a long term prospect and what I mean by that is he's not going out and he's not investing in a company that sells TV antennas he's he's the type of person that looks at a company and he says is this company going to be around 30 to 40 years from now and is their products still going to be something that the world still needs in that duration of time the reason he does is because he likes to buy a company and hold it because when he holds it the growth of that company is actually happening in the market price and then he never pays any taxes on that growth so really the long-term prospects is something that really is wrapped up into taxes and we're going to cover this a whole lot more in the second course of this website but that's the second rule that he always follows whenever he buys stock okay the third one's a little bit harder to to assess as a small investor not a not a large investor like him and that's that a stock must be managed by vigilant leaders now one of the things that I roll up into this tenant is that the the company has to be managed by individuals that manage debt well so one of the things I really stay away from and then Buffett really stays away from is any company that has a lot of debt and I kind of roll that up under this rule so that for us it's a little hard for your career standard investor that's not worth the nearly the amount of money is Warren Buffett it's kind of hard to go in there and have a meeting with the CEO and determine whether it's he's an ethical person that you would wouldn't mind owning part of his business so that's that's the third rule and the fourth rule that we have is that Warren Buffett never buys a stock that is over value must buy stock that's undervalued so what he does is he goes in and like I said before he determines what he thinks the intrinsic value of a stock is and so if he determines that the stock is worth $50 he's always going to try to buy that stock for under what he determined the value to be let's say $40 is what he would be comfortable buying the stock for he's never going to overpay for that and so the name of the game really comes down to is finding that intrinsic value and that's the fourth tenant now I'd like to say that each of these rules each one of these four rules all have to be met he never goes out and says well rule number three and four is met so I'll buy this company he always ensures that all four of these rules are always met or he never buys the company and I recommend that you do the same because it really works out well so let's take a quick at rule number four where a stock must be undervalued now I'd like to highlight that in course two I have an entire unit just dedicated to calculating the intrinsic value and although I know a lot of people would like to jump right into that and start determining what some of these companies are worth there's a whole lot of lessons that you really got to learn to wrap your head around all the terms and the intricacies of calculating the intrinsic value of a company but right now I'm going to teach you a little trick that Warren Buffett did that whenever he worked for Benjamin Graham for a few years and this is a really interesting and quick easy way to kind of pick through companies that are worth investigating and companies that aren't so as we looked at the last four lessons we learned that the market price the earnings and the book value were three very important terms and what Warren Buffett and Benjamin Graham did is they tied all three of these terms together in a quick way to kind of assess a company so when we looked at Nancy's ice cream stand from the previous lessons we took her ice cream stand and we divided it up into 10,000 shares and when we did that we found out that the market price for one share because she was wanting $100,000 for the business that the market price shoe is asking for the business was ten dollars we saw that her net income was twenty thousand dollars when we divided out the shares her earnings ended up being two dollars a share and then the seven thousand dollars in equity that she had off of her balance sheet when we divided that by ten thousand gave us seventy cents in Book value so these were the these were really the important terms that we learned in the first four lessons and what Warren Buffett does with this quick little evaluation tool that I'm going to teach you here is he wraps all three of those terms into one quick assessment and so what we're going to do is is you look at the earnings there that tells us our potential returns you're going to take that and you're going to combine it with your book value which is your assessment of your margin of safety and you're going to get a quick and easy way to assess the company so let's go to the next slide here and as we look I'm going to start off with the earnings so that was the middle number so the earnings here I'm just going to you we talked about the price to earnings ratio in one of the previous lessons and what the price to earnings ratio is doing is we're taking the price and we're looking at the earnings the price is $10 and their names is $2 and all you're doing is you're just dividing those terms or taking the price divided by the earnings which is 10 divided by 2 and that gives you a ratio of 5 and as you learned in the previous lesson the way that you look at that ratio is you say this saying for every $5 I'm going to spend buying this business I can expect $1 in return one year later and so when we see the p/e of five what that really means if the company can actually turn all those earnings into money that's going into your pocket which that's really the thing we're going to figure out in course 2 of this website but let's assume all those earnings go into your pocket that's going to give you a 20% return and all the only way you've got to figure that out is just take the $2 and earnings divided by the market price of $10 and that's 20% so what I want to do is I want to show you when you go on to a website you're looking up a company when you see the p/e is equal to 25 as we move over to the chart on the right when the p/e is 25 that's actually giving you a 4% return and that's assuming if the company can turn all of the earnings into money that's actually going to be realized into your pocket the best you're going to do is 4% with a p/e of 25 now when you look at the P of 20-year return goes to 5% and so as you go clear down to the p/e of five which is the one that we had for Nancy's business to return actually go to clear up that 20% which is pretty high now the thing you got to realize is when the p/e is really low like that then your return is really high which you can expect on the margin of safety is that your margin of safety is going to get worse so let's go ahead and we just look at the price to earnings now let's look at the price to the book value this is a this is a ratio that we haven't looked at yet and it's called the price to book value ratio okay and we're pretty much doing the same thing that we did with the the p/e ratio and now we're taking the price which is $10 and we're dividing it by the book value and when we do that you come up with a ratio and so if you look there we're taking $10 divided by 70 cents and that gives us a ratio of a 14.3 okay so what in the world is 14.3 mean well if you go back kind of the similar phrase we said before every fourteen point three dollars you spend buying this company you're going to have one dollar of equity in the business so that's not very good and just like the the PE the lower the number you go on this the better it is for you because you have more safety on your investment so let's go ahead and look at the price to book compared to the safety here so if you had a company that had a price to book value of a five on the ratio there that means that only 20% of what you're buying that company for let's say it was a hundred thousand dollar business only twenty thousand dollars is going to be the equity in the business so if you bought it for a hundred thousand dollars and you needed to end the business today you'd only get twenty thousand dollars and so as you go down that those numbers through three to one and a half to one and then point seven you can see how that safety changes and that the price to book value when it's a one that means if you'd buy the business today okay and you let's buy the business for a hundred thousand dollars that if you would sell the business immediately after you bought it you can liquidate the business and get a hundred thousand dollars that's what that price the book of a1 equals now the price the book of 0.7 means you could actually buy the business by all those shares and the business and actually make money because the book value is actually more valuable than the price that you bought it for and believe it or not there's actually companies on the stock market that trade like that and just like we learned in the last slide when the when the price the book is that low guess what the earnings are probably really bad so there's your trade-off when the price the book is really low your earnings are probably going to be really bad and when the when the earnings are really good the price the book is going to probably be really bad so that's that's your trade-off so what does all this mean that we're talking about here so what I've done is on the left hand side those are the p/e ratios that's our price in our and then on the right-hand side we have the price to the book value we know that their earnings talk about the return we're going to get on our money and we know that the book value talks about the safety that's involved with the investment so what Warren Buffett and Benjamin Graham did and this is back before they had internet where they could just you know put in a search query of were they wanted the numbers that turn out what they had were really big books and in these books they had all these ratios and the prices for all kinds of different stocks that were trading on the New York Stock Exchange and so what Buffett would do is he'd go down through all the columns of these books because they being really big you know this book was huge and he'd book through the book and he'd see a ticker and then he'd see you know the trading price he'd see the the PE ratio he'd see the price to book ratio and a quick way that he could determine whether it was a company that he wanted to go after or not is he would find the p/e that was low and he'd look at the book value that was low and as you look through this the p/e that he was really focusing on and that he was trying to find as he was trying to always find a business that had a p/e of 15 or lower okay so as you can see there I've highlighted that the 15 and lower is what he was really going after so he was looking for a return of something that was better than 6.6 percent is what he was looking for then over on the price the book which is our safety net he he would try to always find a company that had a priced a book that was better or lower than 1.5 because you can see that's where all your safety was so he came up to him and Benjamin Graham came up with a great idea of well if we're always trying to find a company that has a p/e below 15 and we're also trying to find a company that has the price to book below 1.5 why don't we just take those two numbers and multiply them together and if we multiply the 15 times the 1 point 5 that equals 22 point five so what he said is is I'm looking at this big book of all these ratios and terms I can quickly assess whether a company is something um I'm interested in by taking that and multiplying it times the price the book and if the number comes out below twenty two point five this is probably some company that I really want to take a closer look at and the reason that he was doing this is because as you can see here the little triangle that I have that compares the price to the earnings to the book value that incorporates all the variables that were really concerned with we're concerned about what price are we buying this thing at what do we think the returns going to be and how much safety is involved with this investment and all of those terms are wrapped up into just taking the p/e and multiplying it times the price the book and making sure that that number is below twenty two point five so that's a really quick and easy tool that Buffett used to do whenever he was younger and working for Benjamin Graham that he would go through all these big books and actually try to find companies that were below the twenty two point five now as we go further along in this site and you really get in the course too you're gonna find out that valuations get a lot more complex than this little simple model but if you want to go out and try this with real companies I think you'll find that it actually gives you some really good picks for such a short and easy assessment of just taking two ratios and multiplying them together and seeing if the numbers below twenty two point five okay so I just did this real quick with Nancy's business if you remember the p/e for Nancy's business was a five and then her price the book was the fourteen point three and so what I did is I took the five times the fourteen point three and that equaled seventy one point five so you can see that if we were going to try to run Nancy's business through Buffett's little tool here his low valuation tool she would have missed the mark by a lot she was way overvalued because we want the number to be below twenty two point five and she was at seventy one point five okay so let's transition into just kind of this is this isn't something that we have really talked about but in unit three of this first course that whole unit is focused on understanding the market but Warren Buffett always looks at the market itself is nothing more than something that can facilitate him buying company's at a low price his opinion in the market goes into rule number four which is that a stock must be undervalued he uses that market to his advantage opposed to something that he's scared of so he has the opinion and this is his quote I buy on the assumption that the stock market could closed tomorrow and not reopen for another five years that's that's how he looks at it when he buys that company he truly plans on owning that company forever and that those shares forever because he's buying it based on the assumption that I'm buying this company is going to give me a ten to fifteen percent return based off of what I'm buying and there's no reason why I want to sell a company that's paying me that kind of return so he could care less what it does on the day-to-day all he's doing is he's gone along he's looking at what he thinks a company's worth and if the market's offering him a price that's much lower than what he thinks it's worth well then he buys it the overall view that he has at the market is that some days you'll get offered great buys and other days you'll get offered horrible deals but your job isn't though when it's a bad deal and that you don't take it the last thing I want to talk about is Warren Buffett's opinion on patience and individuality so his opinion on patience is that there's no way you're going to be a successful trader unless you absolutely positively have patience and that you stick to your fundamentals um you know that I love the saying pigs get fat but hogs get slaughtered because it's so true when the person goes out there and they're trying to find the company that's going to give that's going to double or triple their money in three months unfortunately for that person I just don't think that they're going to have much success in the long run you have to be a very patient person that's happy with making ten to fifteen percent returns on your money and if you can do that consistently you're probably going to be very successful in the long run um the other thing that Warren Buffett is really big on is thinking for yourself I can't stress this enough don't ever base your stock investing off of other people's opinions when you do that you're probably going to find yourself in trouble I remember back in 2008-2009 when the market was really low and for me I was extremely excited because I was able to buy companies it just unbelievable values and had almost no debt almost every company I was buying back then still had no debt but yet they were trading at great values and I would look around and everyone was just screaming bloody murder that you know all the whole economies in a collapse and that the you know the world's going to end and everything else but that was the time to be buying great companies and I was thinking for myself and you know it really paid off well and um that the same thing applies whenever the stock market is doing really good and you go into work and you hear everyone talking about what they're buying and that's probably a really good indicator that you probably shouldn't be buying stocks I found out that if I was always doing what everyone else was doing I was probably doing something wrong so that's something that I would recommend to you that as you get out there and you start getting more involved in the stock market and also with bonds which we'll discuss in the next unit if you're doing what everyone else is talking about you're probably falling into the trap that you might not be doing things right so always think for yourself conduct your own valuations on what you think things are worth and then go to the market and see if the marks markets offering you a decent price for that value that you think is worth okay in lesson five we discussed four different lesson objectives the first lesson objective was to learn Warren Buffett's four rules for buying stocks second was to discuss a real basic valuation technique that Warren Buffett used whenever he worked with Benjamin Graham the third was Warren Buffett's opinion on the market and the fourth was understanding Warren Buffett's opinion on patience and individuality so I hope you learned a lot here in the first unit and I look forward to working with you guys in unit 2 where we discuss basic bond valuation and techniques

Channel: Preston Pysh

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Keywords: Warren Buffett stock, Warren Buffett rules, Warren Buffett investments, the Warren Buffett way, essays of Warren Buffett, buffett stocks, Warren Buffett Strategies

Id: _uQjGz6jp2E

Length: 19min 31sec (1171 seconds)

Published: Fri Apr 20 2012