5. Warren Buffett Stock Basics Video Lecture | Become an Expert: Value Investing - Business 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