20. Warren Buffett's 3rd rule - A stock must be stable and understandable Video Lecture | Become an Expert: Value Investing - Business Basics

welcome to course to unit 3 lesson 4
warren buffett's third rule a stock must
be stable and understand in this lesson
we have two lesson objectives
the first lesson objective is to
understand why stability is important
for determining an intrinsic value the
second lesson objective is why is it
important to invest in a company that
you understand so let's get started so
we've made it to the third rule a stock
must be stable and understandable all
four of these rules must be met so let's
go ahead and learn a little bit more
about this particular rule so we have a
person named Andrew and we've been
tracking Andrews equity earnings and
debt for the last ten years from 2002 to
2012 and what we're going to do is we're
just going to assess Andrew in each one
of those areas the equity the earnings
in his debt that he's managed over the
last ten years for himself this is not a
company this is just Andrew okay so when
we look at Andrews equity over the last
ten years we see that it's had its ups
and it's downs and generally it's it's
moved in the upward direction when we
look at his earnings which you can see
the chart that the numbers on the left
and then you can see it graphically
represented on the right those are his
earnings you can see that they've
generally grown but they've kind of had
their ups and downs as well and recently
in the last five years it's been kind of
steady in level then when we look at his
debt his debts kind of all over the
place it's been high it's been low and
it's generally kind of stayed at the
same level which is kind of high
compared to how much equity he had so
the point that I'm getting out with this
is if we were going to predict how much
equity Andrew would have in the year
2022 it might be a little bit hard for
us to determine that based off of his
past performance now that doesn't mean
that in the future he could just start
having very sustained equity growth he
could have very sustained earnings a
very consistent every year was pretty
much the same that could happen but most
likely that won't happen this type of
person will continue to live this this
style this lifestyle
and he's going to have those ups and
downs most likely in the future which
makes predicting how much he's going to
be worth because that's really what this
is is equity is his net worth if he
would liquidate or he would die andrew's
assets would be added up and then
subtracting out his liabilities that
would be his equity but predicting how
much equity he would have in 10 years
from now might be a little bit difficult
based off of his previous lifestyle in
the way that he lives his life so let's
look at a different person let's assume
that we're going to look at a woman
named Linda now Linda lives a completely
different way than Andrew and Linda has
we're looking at Sessler equity earnings
and debt and when we look at her equity
you can see that her equity grows very
steadily every single year almost by the
same margin and it's a very linear graph
when we look at that equity graph so as
we look at Linda let's say we wanted to
estimate how much equity she would be
worth in ten years from now I think
everyone can agree that would be a lot
easier to estimate where Linda would be
compared to Andrew so as we look at
these two people the thing that I want
you to take away from this scenario is
that businesses are managed just like
individual people the business that we
want to find that we want to invest in
is that business that is very steady
very predictable because when we when
we're trying to figure out the intrinsic
value of a business we're going to be
adding up all the cash that we could
take out of the business over a 10-year
period and when we're making that
assessment it's very difficult to do
when you have a business that moves like
Andrew opposed to a business that moves
like Linda so just because a business
has volatile numbers doesn't mean it
won't make a lot of money in the future
that's not my my point of pointing this
out to you Andrew could be worth ten
times as much as Linda in the future but
the reason I show this is because Andrew
is unpredictable you can't really
predict where he's going to be where
Linda you have a much better idea of
where she's going to be and so that
difficulty to predict that value
of where something's going to be in the
future that's risk and what we're trying
to do is minimize our risk while still
having some decent returns so what I'm
going to do now is I'm going to show you
some real companies not these scenarios
with individual people I'm going to show
you Disney and XM radio again
and what we're going to do is we're
going to look at their equity we're
going to look at their debt to equity
and we're going to look at their
earnings and see how it's progressed
over the last ten years and then what
we're going to do is compare the two so
I'm going to go to MSN Money and I'm
going to first pull up Sirius XM radio
okay so here we are at the top page for
MSN comm and we're just going to come
down to enter our ticker and we're going
to enter Sirius XM radio which is s I
are I will hit enter okay and it takes
us to this top level page where it gives
us all of our information now one of the
tools I really like on MSN Money is
being able to go back and look at the
ten-year trends so to do that you're
going to come over here to the left hand
side under key ratios and we'll go ahead
and click there and then at the top up
here it has a ten-year summary and we'll
click on that when it brings up this
ten-year summary we can come down here
and we're going to look at the book
value per share and how it's changed for
Sirius XM Radio over the last ten years
so and you'll see it says book value per
share and if you go back into the first
course if you're not familiar with this
you're probably have to go back to the
first course it was under course 1 unit
1 lesson 3 where we learned about book
value and all that is is equity per
share so we're really looking at the
equity of the business and how it's
changing over a 10-year period so when
we look at Cirrus we can see back in
2002 it was worth $7 and 33 cents a
share and then the next year went down
the 1 dollar and 16 cents and you can
see that progression and how that number
really dipped enormous amount and then
in the last three years they've been
just slowly making some growth in there
equity okay the next number over if you
remember from Warren Buffett's first
rule where we were talking about the
debt to equity ratio this gives you the
debt to equity ratio for the average of
the debt to equity ratio for each year
so this is a really a great number to
look at so you can see the trend and how
this company's been managing their debt
over the last ten years you can see if
you remember we want to find a business
that has a debt to equity below 0.5
there e high numbers even some negative
equity right here that's what would make
this this number a negative so those
numbers are very high and that's
something that you'd really want to
avoid if you were going to be investing
in this company now as far as the
earnings per share which you'll remember
from course 1 unit 1 lesson 2 that's a
very important number because that's
essentially your profit per share so in
order to find that unfortunately it's
not on this chart but we can go to right
over here on the Left where it says
10-year summary if you click on that
it's going to show you the EPS right
here and this is the trend for the last
10 years so you can see the earnings on
Sirius XM radio negative 6 dollars a
share negative 38 cents a share negative
57 dollars or 57 seven cents a share and
it goes clear up here only recently in
the last two years have they had a
positive earnings per share with one
cent and seven cents okay so that's the
trend of this company and and what I'm
going to do now is I'm going to show you
how that would look on a graph if we
plotted all those numbers that I just
showed you
so I've plotted out two of the numbers
here I've plotted out the equity for
Sears and I've plotted out the debt to
equity ratio so when we look at the
equity you can see that on that chart
that's not a good trend whenever you're
looking at equity you want it to be
going in a positive direction not a
negative direction and not only do you
want it to be going in a positive
direction but you want that chart to be
really linear because the more linear
that it is the more predictable it is
for you to assess how much that equity
is going to grow over the next 10 years
now when we look at the
to equity for Sears unfortunately the
the debt to equity was so high in 2008
that the chart you really can't even see
how those values were fluctuating that
much for all the other years but to go
from a 15 point 5 in 2010 down to a 4
point 2 8 2011 those are enormous
changes in that debt for that company
and that's something that you want to
avoid at all cost is a company that is
moving in all these different directions
like Cirrus is so when we're trying to
predict the intrinsic value of this
company that's exceptionally hard to do
because in the past that the company has
been all over the place it's just so
sporadic that you can't come up with an
intelligent estimate of what you think
this company would do over the next 10
years
it's hard enough to predict what they're
going to do in the next year let alone
10 years so if I was going to be trying
to calculate the intrinsic value of
Cirrus I would have absolutely stopped
right here I would have never even gone
to the calculator which you're going to
learn about in the next lesson this this
would have been the end of the road for
me with this stock so now let's go ahead
and take a look at the numbers for
Disney so let's go ahead and go back to
MSN money and we'll pull up the Disney
numbers and then I'll show you the
charts for that okay so here we are for
the Walt Disney Company which they're
ticker is DIS and you just type that in
here at the top type in D is and it will
take you to this page and just like we
did before we're just going to scroll
down and we're going to come over here
to the key ratios tab we're going to go
ahead and click that then we're going to
go up to the ten-year summary okay
and it takes us to this page now when we
look at the book value which is just the
equity per share you can see that in
2002 the equity was $11 11.8 goes up to
13 you see this nice steady trend that's
exactly what you're looking for whenever
you're trying to find a business now
when we look at the debt to equity we
can see that Disney has generally manage
their debt below 0.5 which is exactly
the number that we want to see it
underneath now let's go over to look at
the earnings so to do that we have to
click on the ten-year summary
there and now we're going to look at the
earnings per share this is generally
trending and started off at 60 cents ten
years ago and now it's up to two dollars
and 50 cents and you can see that is
trending up it keeps increasing and
that's exactly what you want to see with
your earnings you always want to see
your earnings increasing like that if
possible but at a minimum if the
earnings are consistent let's say it was
two dollars and 50 cents for all ten
years that's wonderful
when you see it growing even better so
let's go ahead and chart and let's let's
put all these numbers on a chart so we
can graphically see what those numbers
are doing okay so on the Left we have
the equity for Disney and you can see
that is a nice linear graph over the
last ten years and you can see how
they're growing that equity when you
have a company that's growing their
equity nice and consistent like that
you're going to see that reflected in
the market price the market price is
generally going to trend exactly with
the equity now the debt you can see that
back in the early 2000s they had it a
little bit above 0.5 but recently in the
last 5 years they've maintained it below
0.5 and it's all been trending in a
downward direction so that's that's
obviously really good as well
so if we're looking at a company that's
stable now I'm not saying that this is a
company that you should buy because we
still have to figure out what it's worth
but if we're trying to predict where
this company is going to be in 10 years
I think we can all agree that this is
going to be so much easier to predict
than a company like cirrus now in 10
years from now Sirius XM radio might be
the best company on the universe and
Disney might be the worst but what we're
trying to do is we're trying to be able
to predict which company is going to be
where in 10 years from now and based off
of these charts based off of these
important numbers we can see that the
Disney is much more stable and
calculable than Sirius XM radio so in
this rule we not only want to have a
stable business but we want to have a
business that we understand for me
personally I've never really understood
the XM radio thing it's hard for me to
understand why people would want this
service now I have friends that swear by
this company and they love the service
but
me it's not something that I really
particularly care for and something that
I would obviously not invest in I don't
understand it
so for me this is probably a really bad
business to own because it's not
something if say they change their
service and it's no longer something
that's that's what a lot of people like
I wouldn't know that because I don't
subscribe to this I don't use it so
that's not something that I would be
attuned to if I owned this company so
you generally want to stay away from a
company that you really don't understand
because you're not going to really
understand the ins and outs of the
direction that the company is moving now
as far as Disney I've been there a few
times and I'm very impressed with their
product I think that it's a viable
product I think it's gonna be a product
that's going to be around for years to
come
and so I somewhat understand this so if
the numbers would check out and let's
say that Disney would be a good buy then
this would be a company that I would be
comfortable buying this part of the role
is something that a lot of people might
not follow and I would strongly
discourage you from that because it's I
think it's really important to
understand the businesses that you
actually own so this concludes our third
rule a stock must be stable and
understandable and hopefully those tools
that I showed you on MSN money will come
in handy
make sure you go back there and try that
with a couple different companies so you
can look at how that equities grown
which is the book value you can look at
that earnings per share and see how
that's trending and you can also go back
and look at that debt to equity and
apply that to a lot of the lessons that
we learned and in Warren Buffett's first
rule which a stock must be managed by
vigilant leaders so the next lesson
where we're going to talk about how a
stock must be undervalued we're going to
be finally figuring out the intrinsic
value of a business using the Buffett's
books calculator so this concludes
course to unit 3 lesson 4 Warren
Buffett's third rule a stock must be
stable and understandable we learned why
stability is important for determining
the intrinsic value and we learned why
it was important to invest in a company
that you understand so I really look
forward to seeing you guys in the next
lesson where we figure out the intrinsic
value of a company