5. Warren Buffett Stock Basics

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. Course author: Preston Pysh