How to invest in stocks like Warren Buffett

Investment course from BuffettsBooks.com【Beginners, Intermediate and Advanced level】

Posted by Chaoli Zhang on September 4, 2017

The video course can be found here: Youtube BuffetsBooks series, and their website: BuffetsBooks.com


【Beginners】

L 1 WHAT IS VALUE INVESTING

Summary

In this lesson we first learn about value trading. Here the trader know the value of something he owns, and look for another item that he can trade it for that has a higher value. This may be a viable strategy for some merchants, but the bottom line is that as time progresses the value of the items does not increase in value. A value trader need to keep putting in time and energy to find a new item with a high value to trade for, as well as he needs a very motivated seller who is actually interested in trading with him.

In value investing the investor is holding on to an asset, and this asset increases in value over time even though he did not put in any time and effort. A fish pen is an “item”. It will continue to hold its value, but not increase in value. An apartment building on the other hand where you are renting out units can be considered an asset as it will continue to put money in your pocket. This can also be perceived as the definition of an asset: “It continues to puts money in your pocket as long as you own it”. The opposite of an asset is a liability. A liability is taking money out of your pocket as long as your own it. An example of this is a car. While it might be practical to own a car, at the end of the day it is an expense.

Wealthy people own assets and continue to accumulate them. It could be apartment buildings, stocks, bonds, just to mention a few of the options.

We also learn how Warren Buffett is looking at stocks. As a value investor he estimates the value, and if it is considerable higher than the price, he simply buy the stocks and hold them. As time progresses the value of continues to compound, making him more and more wealthy.

Warren Buffett learned his simple yet powerful investment strategy from his college professor Benjamin Graham. Warren Buffett also later worked for him in his investment company and studied his two books: Security Analysis and The Intelligent Investor. Parts of these books are not easily accessible for the common stock investor, and that is where BuffettsBooks.com comes into the picture. Our site teaches the same techniques Warren Buffett was taught about value investing in simple video tutorials.

New Vocabulary

  • Value Investing Buying assets that has a higher value than the price you can buy them for. The assets will continue to make you wealthier even though you do not put in any additional time and energy.

  • Asset Items of varies character that puts money in your pocket month after month as long as you own them. Stocks, bonds, renting out apartment units, are just a few examples of assets. As a value investor you want to accumulate as many assets as possible.

  • Liability Items that takes money out of your pocket as long as you own them. A car or a boat is just two examples of liabilities. These items would consistently lose value, be costly in maintenance, fuel, insurance.

  • Intrinsic Value Simply put, it is the actual value of a security (a stock or bond) as opposed to the market price (or trading price of stock or bond). Your job as an intelligent investor is to determine an investments intrinsic value (follow the steps in this website and you should be on the right path).

L 2 Ice cream business

  • Net income (earnings)
    • divident
    • equity
  • board of directors (reprentor of shareholder)
  • Find companies that trade for less than 15 times the earnings

L 3 Balance sheet and margin of safety

  • income statement (company profit)
  • balance sheet (margin safety): what would happen if the business liquidated right now !
  • cash flow statement
  • market price for the ice cream stand: $200,000
  • Equity = Total assets - total liability
  • The closer the equity is to the market price, the safer the investment

L 4 Finding basic stock terms

  • value ice-cream stand: $100,000
  • shares outstanding: 10,000
  • so 1 share = $10
  • EPS (earnings per share) = Net income / share outstanding

  • book value (equity per share) = equity / share outstanding
  1. P/E = Market Price / EPS

    For every # dollars I spent buying this stock, I should receive 1 dollar in profit a year later

  • stock investing is locrative: so many people don’t analyze data
  • always calculate the intrinsic value of the business, then compare the value to the price it trades for.

L 5 Warren Buffett stock basics

  1. A stock must be stable and understandable
  2. A stock must have long term prospects
  3. A stock must be managed by vigilant leader
  4. A stock must be undervalued

P/E ratio * P/BV ratio < 22.5

L 6-8 Bond?

  • risks:
    • company or government failure
    • interest rate change (becomes higher)
    • inflation
    • order of equity distribution
      1. bond holder
      2. preferred share holder
      3. share holder
  • Face/Par value: $1000
  • interests rates go up, bond prices go down (losing money!!!)
  • Simple interest
    • add up all the coupons
    • Coupon yield: 1 year coupon payment / par value = 50/1000 = 5%
    • Current yield: annual coupon divided by the price
  • Compound yield
    • yield maturity (reinvesting at 5%)

L 9 Stock market

  • Stop order (sell/buy at fix prices)
  • Market order (sell/buy at flexible available price)
  • The essence of the stock market is to determine what share actually worth.
  • limit order: if something is great than $# then execute the trade.

L 10 Stock market crash and bubbles

L 11 FED

  • FED: United States Federal Reserve which ultimately controls the US economy

【Intermediate】

L 12 Financial risk

  • Risk Vs Reward
  • what is the baseline value for risk and reward
  • what causes financial risks in a business

L 13 Inflation

  • what is inflation
    • Things cost more money to buy
  • how and why does government inflate the currency
  • how does inflation affect bonds and stocks

L 14 S&P rating

  • what is credit rating
  • what does a rating tell me about risk

L 15 Yield curve

  • what is yield curve
  • how can I use yield curve to predict market behavior

L 16 How to use a bond calculator

  • How does the price of a bond change with interest rates
  • How to use BuffettsBooks.com Bond calculator: Calculator

L 17 Buffett’s Four Rules to Investing

L 18 Buffett’s 1st Rule (vigilant leadership)

  • define vigilant leadership
  • understand the debt to equity ratio
    • longterm debt/equity <0.5
  • understand the current ratio
    • total current asset/total current liability >1.5
  • what level of debt are acceptable

L 19 Buffett’s 2nd Rule (stock must have long term prospect)

  • how do we identify a company with long term prospects
  • what is capital gains tax
  • what is difference between short term gains and long term gains

L 20 Buffett’s 3rd Rule (stock must be stable and understandable)

  • stability is important for determining the intrinsic value
  • investing a company that you can understand is vital

L 2f Buffett’s 4th Rule (Intrinsic Value Calculation. Most Challenging!)

  • a stock must be undervalued
  • how to calculate intrinsic value of the stock
  • how to use BuffettsBooks.com intrinsic value calculator

Re-watch the video everytime you come back to this point:

Buffett’s Rule 4

L 22 Preferred Stock

  • what is a preferred share
  • what are the considerations
    • read the certificate of designation
    • buy cumulative preferred share
    • avoid perpetual terms
    • beware of callable securities

L 23 calculate yield to call and how to buy preferred stock

  • where to conduct research on preferred stocks
  • where to find essential elements of a preferred stock
  • how to determine yield to call on a preferred stock: YIELD TO CALL calculator

Just re-watch the videos

L 24 calculate book value with preferred stock

  • how to account for preferred stock with balance sheet
  • what is a 10-Q
    • use 10-Q to calcuate book value/share

Just re-watch the videos

L 25 income investing

Income investing is the concept of purchasing bonds and stocks that will provide income for the owner in retirement through stable coupon and dividends. The amount should be so high that when you are living the life style you want to, your portfolio would remain the same or even increase.

A practical example can be used to explain this concept. Imagine that you have $1,000,000 in retirement and you are able to make a stable 5% return. In that case you would receive $50,000 each year in proceeds from your investment. That means that if you expenses are equal or below this amount you can maintain the lifestyle for the rest of your life.

Which approach should you take if you are near retirement age and you want to invest in companies that benefit you right now and well into your retirement? The answer is quite simple: “Invest in stable companies that pay dividends”.

To illustrate this, it is shown is this lesson how high debt companies through the recent financial crisis dramatically cut their dividend payments. This is surely not a situation you want to be exposed to if you are supposed to pay your bills with your dividend payments. Companies that have a much lower debt on the other hand managed to sustain or even increased their dividend.

One simple rule to remember when speaking about income investing: “Always purchase assets that will increase your cash flow next month”. It could be low debt stocks paying dividends, or a bond paying coupons. Income investing has a compounding effect that is hard to find elsewhere.

Typically the attractiveness of your investment opportunities constantly changes. The benefit of a continuously increase in monthly cash flow is that you can keep investing in the assets that is currently undervalued.

Finally in the lesson a conclusion is presented:

Income investing provides a quarterly payments during retirement Income investing provides a stable stream of cash that allow you to buy the currently most undervalued assets. This is especially beneficial prior to retirement. As a rule of thumb 1/3 of earnings as dividend and 2/3 as retained earnings is desired.

L 26 - 27 cash flow statement

The cash flow statement can be broken down into three components:

1) Operating Activities (Look for a high positive number)

This is the most important number to look for. This is the cash that is produced by the company’s operations, and without that, the cash flow from investing and financing activities cannot be healthy. While the net income is a key number and is also included in the calculation of operating activities, many other factors influence how much cash the company is actually making. If you see a high positive cash flow from you operating cash it is typically a positive of a healthy business.

2) Investing Activities (Look for a negative number

All companies need cash to reinvest in the business. It might be for new machines, cars or property. Often companies also invest in common stock or bonds, and all of that is too finance by the investing activities. If you see that the cash flow from investing activities is positive, this would imply that the company has sold income producing assets. While that may nice in the short run to obtain more cash, this would most often be followed by a decline in in later earnings. Therefore you want investing activities to show a negative cash flow.

3) Financing Activities (Look for a negative number)

Financing activities includes handling of debt and relationship to the investors, and is a neat number to investigate for management’s financial discipline. If you see that this number is positive it would typically imply that the company has obtained more debt, or in some cases that it has issued more shares. While tis extra cash can be very useful in some cases, it can also be a sign of trouble. An increase in debt means higher interest payment in the long run, and common stock issue dilute the investor’s ownership of the company. A negative number on the other hand indicate that debt has been repaid, common stock has been bought back (increasing investors’ ownership of the company), or dividend has been paid out to the shareholders.

Examples on real case flow statement can be found here: Examples

【Advanced】

L 28 WHEN TO SELL STOCK

1) When a higher return is expected by trading with another asset (considering the capital gains tax)

One thing that might be tempting to do is keep trading your stocks when you find a new company that you really like. The problem about this approach is that you have to pay capital gains tax every time you sell a stock with profit. We learned more about capital gains tax in lesson 19 and saw that it was a large expense that required unrealistic stock picking skills. Continuously paying tax on your profit instead of deferring your tax obligation implies that the amount of money that you invest for decreases.

Therefore, when you sell stocks, you should evaluate if the expenses you incur in terms of tax outweigh the higher expected return on the new stock pick.

To fully understand when you should sell stocks, it is recommended to fully understand the calculation of intrinsic value that was taught in lesson 21.

Assume your current holding is called XXX and the new stock you are looking at is called TTT. By following a few simple steps you can determine whether you should sell your stocks or not.

1.1) Calculate the expected annual return for stocks XXX and TTT based on the current market prices and intrinsic values 1.2) Subtract the cost of capital gains tax from stock XXX 1.3) Calculate whether stocks XXX or TTT yield the highest expected annual return based on a given time frame.

2) When the company changes the fundamentals

Another important factor Warren Buffett really looks for when selling his stocks in a company is whether the fundamentals of the business are changing. What that means in practice is whether the first three rules are being broken. As we have learned in lesson 18-20, that would happen in situations where: the company is no longer managed by vigilant leaders, the company no longer has long-term prospects, and where the company is neither stable nor understandable.

One final thing to take away from this lesson is that the process of determining if stocks should be sold or not is actually not as complicated as it may look at the face of it. With a little practice, it becomes fairly easy.

L 29 WHAT IS RETURN ON EQUITY

The Return on equity (ROE) offers the investor a very quick glance at whether a particular stock that he may be interested to invest in is worth it.

A prerequisite for understanding Warren Buffett’s assessment of ROE is to know how he values stocks and bonds. According to Warren Buffett, bonds and stocks can be valued similarly. The value of a bond is simply the payment of coupon and the par value in the end. While the bond can be bought at a discount or a premium (below and above par value) it cannot trade at a premium at the end of the term.

The owners of stocks do not receive fixed coupons, but receive variable dividends instead. Warren Buffett compares the par value of a bond with the book value of a stock, with the clear caveat that a stock can trade at a premium and that there is no maturity date.

To understand the implication of this, imagine a company that has a book value (or equity per share) of $10 and retain $5 in EPS one year. That would mean that the book value of that same stock increased to $15 – a 50% gain on book value. In investment terms, this is called a 50% ROE. According to Warren Buffett, this will be reflected in a 50% increase in market price:

The percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value – Warren Buffett

If you compare that to a $100 book value company ($100 in equity per share), which makes $5 per share, you can only expect this company to increase its equity and therefore increase the market price by 5%. In other words the ROE is 5%.

L 30 WHAT IS VOLUME

we understand the importance of stock volume. Although the volume won’t help intelligent investors learn the intrinsic value of a company, it can be used as a tool to help predict market behavior.

Investors are often fooled into believing that the market price of a stock is determined by all the shareholders. This idea is false. When we look at the volume of a company on any given day, we can quickly get a sense of how many traders are actually determining the price of a stock when we compare this number to the shares outstanding. This ratio – volume/shares outstanding – provides a good idea about the number of traders moving into and away from the company. When the company trades at a very low volume, we can generally say that the shareholders agree with the market price. Likewise, if the volume is very high, we can generally say that the shareholders disagree with the market price.

In the video, we demonstrate this principal with Wells Fargo (WFC). When you look at the historical market price for WFC, you will learn that on the day the volume was the highest in ten years, the market price was at an all time low. This idea of shareholders disagreeing with the market price when the volume is relatively high is an important point that stock traders can use to their advantage. Always remember, volume can mean that the stock is overpriced or underpriced. The peak or valley is for you to discern.

The takeaway from this lesson can be summed up to the following:

  • Remind yourself that traders only determine the price of the stock, not the value
  • Stock volume can be an indicator for when to buy stocks or adjust your portfolio in general

L 31 STOCK TERMINOLOGY

Examples on how to calculate those terminologies can be found here: video


  • Shares Outstanding: Shares outstanding refer to the number of shares that are held by all the stockholders of the company. If there are 100 outstanding shares and you own 1 share, you own 1% of that company. Shares outstanding are reported numbers that require no calculation.

  • Earnings per Share (EPS): Knowing how much money a company makes it very neat, but as a shareholder it is often more important to know what the earnings are on a per share basis. The reason is that as a shareholder, you are being rewarded according to your level of ownership. The key ratio is calculated as Net income / Shares outstanding.

  • Diluted EPS: Diluted EPS is very similar to EPS. The difference occurs when companies reward employees with stocks. More stocks mean that the ownership, including the earnings becomes diluted. Therefore, Diluted EPS is therefore a more accurate measure to use than normal EPS. It is calculated as: Net income / Diluted average shares.

  • Price to Earnings (P/E): The Price to Earnings or P/E is a very commonly used key ratio to indicate the price level of a stock. For instance, a P/E of 18 means that $18 is the cost of $1 earnings a year later. It is calculated as: Stock price / EPS

  • Stock Volume: Stock volume is the number of shares of a given stock that are being traded on a daily basis. This number is reported, and therefore, it doesn’t come with a formula.

  • Dividend Rate: The dividend rate is dependent on how much the management has decided to pay out as dividend. For example, if a company decides to pay out $1 in dividend per share, the dividend rate is $1.

  • Dividend Yield: The dividend yield indicates the size of the return an investor can expect to gain at the current price. If the stock price is $100 and each stock pays off $3, the yield is 3%. Often, this is simply reported as 3 with no percentage sign, but in any case, that is how it should be interpreted. It is calculated as: dividend rate / stock price.

  • Debt/Equity Ratio: The Debt/Equity ratio compares the amount of debt the company has incurred when compared to the equity of the company. The equation is very simple to remember: Debt / Equity.

  • Book Value: The book value number is sometimes known as the equity per share. What that number tells you as an investor, is if all the company’s assets were being liquidated and all debt was paid off, this is the cash you would be left with. The formula: Equity / Shares outstanding.

  • Price/Book Value (P/BV): Stocks are typically not priced at book value. Investors can be willing to pay a much higher price for an asset – like a patent – than what you can read from the books. Typically, the reason for this is that the investor deems high earnings potential or because it is considered a safe company. What the investor can take away from this number is a snapshot of the margin of safety. For instance, if a stock that’s trading at a high P/B is considerably above 1.5, there is often very little margin of safety. Warren Buffet would want to omit this too and in other words, the stocks may be overpriced. Formula for P/BV: Stock price / Book value.

  • Equity Growth: The equity growth measures the book value growth per share over a given time period. The BuffettsBooks.com intrinsic calculator can help you calculate that number using book value inputs over your desired period of investigation.

  • Return on Equity: Any investor would want the Return on Equity ratio to be as high as possible, stable and increasing. Since the equity is the shareholders money, the ROE is a measure of how well the shareholder’s money is reinvested in the business. The formula for ROE is: Net income / Equity

  • Current Ratio: The current ratio indicates the amount of cash the company can expect to convert over the next 12 months. It also includes the amount of cash the company is expected to pay out over the same time period. Current ratio is calculated as: Current assets / Current liabilities.

L 32 A STOCK SCREENER

In this lesson, we learn how to use a stock screener. There is a variety of stock screeners on the market, but a great advantage with Google’s stock screener is that it is completely free. All stock screeners have one common purpose. Given the quantitative input criteria the investor puts in, the output will be the companies that meet those criteria.

Stock screener provides a large number of different key ratios that all can be found useful depending on the investor and his investment strategy. In this lesson, BuffettsBooks.com is setting the criteria based on the following key ratios:

  • Market Cap
  • P/E Ratio
  • Dividend yield
  • P/B ratio
  • Total Debt/Equity
  • Current ratio
  • Return on equity 5 year average
  • Return on equity most recent quarter

It is really important to emphasize that there is no right or wrong criterion to use. For instance, Warren Buffett likes a P/E ratio below 15, but if you have a strategy where you would accept a P/E that is 20, it is completely fine. Also, in this lesson, we learn that the selected criteria depend on the general state of the economy. For example, in a very high stock market you need to loosen up on your criteria to find investment prospects, while a stock market crash would allow you to be very picky in your criteria for stock selection.

In the end, a stock screener is nothing more than a tool that gives you an indication of potential bargains. To figure out if it is a stock worth investing in, a comprehensive qualitative study must always be conducted as well.


One example showing how to use google stock screener

L 33 GOODWILL ON A BALANCE SHEET

Summary

It’s a prerequisite to understand the difference between a tangible and an intangible asset at the very beginning of this lesson before we go into details. Examples of tangibles assets include a plant, inventory, or cash – it is physically tangible, which basically means that you can feel and touch the asset. Examples of an intangible asset include brand name, customer loyalty, and patents. You can’t touch an intangible asset.

While this lesson teaches us that the goodwill is in fact a tangible asset, a balance sheet would often show that goodwill is separated from intangibles.

Under all circumstances, the natural question arises as to how a company can list an asset on their balance sheet that is intangible. The principle is very simple: “The amount that the parent company paid more than the equity value of a subsidiary is listed as goodwill”.

Imagine that Apple (parent company) wants to buy a smaller company (subsidiary). If Apple would pay 50,000 and the equity in that company is $20,000, Apple can list goodwill of $30,000 ($50,000-$20,000). As the goodwill is listed as an asset, it would also be included as equity in the consolidated financial statements of Apple.

Remember that Apple also acquired the equity of $20,000 in that company; therefore, Apple can list the whole purchasing price of $50,000 of the subsidiary as an asset. Now, it is important to note that buying other companies is not a method to grow assets that are turned into equity. The $50,000 which was the purchasing price is money that Apple has earned previously, so basically Apple is simply moving things around on their balance sheet.

A question that logically arises when discussing goodwill is why a company like Apple would pay a premium for the equity in another company. The subsidiary might have capabilities that are of a high value, but at the same time they aren’t recognized in the financial statements. Examples include brand name, customer loyalty, patents, and employee knowledge.

The challenge in security analysis is to value a company that has goodwill. Warren Buffet doesn’t place a lot of emphasis on the goodwill you find on the balance sheet (called accounting goodwill) Instead, he places a lot of emphasis on what he calls the economic goodwill. Economic goodwill is what can be earned more than the market return from intangible assets. This is also why businesses can be worth far more than net tangible assets. An example of this could be a company with high brand recognition that can charge a higher price for their products because their customers are very loyal.

Warren Buffett is not only focusing on economic goodwill leading to a higher return right now. Another great argument is that while the economic goodwill is inflation proofed, the tangible assets that typically need to be replaced are not. For that reason, if economic goodwill is sustained, more profit will also be made over time.

Benjamin Graham has a different view on goodwill from that of his student, Warren Buffett. Benjamin Graham looks at a company as if it were prone to liquidate the very next day. If that should occur, net tangible assets are the only things left to value the business. For that very reason, he therefore believes that the margin of safety is the difference between the market price and book value. One thing to keep in mind though: When talking about Benjamin Graham, you must understand that he conducted a lot of his research in the 1930s after the great depression, and that might explain his more skeptical approach.

BuffettsBooks.com has the opinion that economics goodwill is great as it is inflation proofed, given that you plan to hold the stocks forever. Strong earnings and minimal debt is also a requirement. Still, a reasonable amount of tangible assets for safety is recommended.

New Vocabulary

  • Tangible Asset: An easy way to remember what a tangible asset is simply to keep in mind that it is “tangible”. For example a company can own a car. A car is tangible, or in other words, it’s something you can touch.

  • Intangible Asset: An intangible asset is something that you cannot touch. A company like Coca-Cola might have a strong brand name, but the brand name is not something you can lay your hands on.

  • Consolidated Financial Statements: When a company has bought another company’s financial statements, they must be prepared for both companies combined. This is referred to as consolidated statements or as financial statements for the “group”.

  • Accounting Goodwill: The accounting goodwill is the amount of goodwill you find in the balance sheet. Neither Warren Buffett nor Benjamin Graham put much emphasis on that.

  • Economic Goodwill: The economic goodwill is the concept that explains why a company can be worth far more than its net intangible assets. It might be because the brand name is strong, or customers are very loyal. While Warren Buffett believes that economics goodwill creates a lot of value to the business, Benjamin Graham is of the opinion that the overall worth of the goodwill and intangibles is very little.

  • Net Tangible Assets: When subtracting intangibles from equity in the balance sheet, you end up with the net tangible assets. That is also the amount of money you end up with if the company is liquidated.

L 34 Buffett’s owner’s earnings calculation

Summary

In this lesson, students learn the difference between accounting earnings and Warren Buffett’s Owner’s Earnings.

When an Investor looks at the bottom line figure on the Income Statement, they find the Net Income. This is the profit the company has produced for the given time frame. Although many people use the net income to value a business, Warren Buffett takes a different approach, and calculates what he calls the Owner’s Earnings.

In order to understand the concept of Owner’s Earnings, one must understand the two paths taken by the Net Income after it’s produced. The first path is a potential dividend payment. Any funds that take this path are immediately valued as Owner’s Earnings. The remaining amount of net income after the dividend payment is then used to invest back into the business. This money also has two paths. While one path is to use the money to reinvest into the maintenance and care of the already existing equipment, the other path is to spend the money on expanding the assets of the company. If the funds flow in the first direction, called Capital Expenditures, the company’s book value will display little or no growth at all. If the funds flow in the second direction, the money will add new streams of income to the business and the asset will be added to the current equity of the business. This second amount is added to the dividend and the total is referred to as the Owner’s Earnings.

If an individual is interested in calculating the owner’s Earnings, he/she could simply take the funds from the Operating Activities section on the Cash Flow Statement, and subtract it from the Capital Expenditures – also found on the Cash Flow Statement.

Remember, the true Owner’s Earnings is nothing more than the book value growth and the dividends combined.

In order to read Warren Buffett’s exact notes on Owner’s Earnings, be sure to follow this link to his 1986 Shareholder’s Letter. The portion on Owner’s Earnings can be found at the bottom of this document.

The most important thing to take away from owner’s earnings is to understand the concept more than remembering simple formulas. As a shareholder you want to know the amount of value the company is making, and how much of that is flowing back to you. This is, in essence, what owner’s earnings are all about. Accounting both intentionally an unintentionally misleads the investor, but at the end of the day, the real value that is being created for the shareholder is all that counts.

At the end of the lesson four main pointers are provided:

  1. Fully understand the difference between owner’s earnings and accounting earnings
  2. Continue to value companies based off the book value growth and dividend
  3. When assessing the future earnings of the business, ensure that the estimate remains stable or is increasing
  4. Check the Cash flow statement quarterly, to ensure that the ratio between the operating activities and Capital Expenditures remains intact.

Owner’s earnings are just one example of how Warren Buffett has reinvented investment and seen new opportunities where he is one step ahead of the pack. Tap Dancing to Work by Carol Loomis gives you a unique insight of Warren Buffett’s more advanced thoughts and actions on investment. I’ve read this book and enjoyed it very much. Carol does an outstanding job capturing important Buffett topics.

New Vocabulary

  • Accounting Earnings: The accounting earnings are often referred to as “reported earnings” and it is located at the bottom of the income statement as “net income”.

  • Owner’s Earnings: The owner’s earnings are referred to as “Free Cash Flow”. The accounting earnings that is in reality turned into earnings for the shareholder. It is calculated as: Cash from Operating Activities – Capital Expenditures.

  • Capital Expenditures: The capital expenditures are the expenses the company incurs when replacing assets. Examples of assets that need replacement are typically cars, plants, and other operating equipment.

L 35 INTRINSIC VALUE CALCULATOR

THE DISCOUNT CASH FLOW (DCF) MODEL VALUING OWNERS EARNINGS

Summary

The DCF calculator has a different approach to valuating a stock when compared to the intrinsic value calculator, which has been presented previously throughout the courses. The DCF calculator uses cash flows for valuation. The calculator typically first calculates for the coming 10 years, and then in addition it estimates the value of the stock if you hold it forever – this is also called perpetuity.

To get the easiest insight into how the calculator works and making it as user friendly as possible, the DCF calculator is broken down into 6 simple steps:

  1. Estimate the free cash flow
  2. Estimate the short term growth rate
  3. Determine the short term
  4. Determine the discount rate
  5. Determine the growth into perpetuity
  6. Input the number of shares outstanding

In the following lesson, a further elaboration of each step is shown. It is important to emphasize that when talking about estimates, estimates are exactly what you get. They are qualified guesses about the future – nothing more and nothing less. This is also why you will see that two people with the same information available will come up with two different numbers for the value of a stock.

  1. Estimating the Free Cash Flow (FCF) is the first step in the process and the investor is advised to look back at the 10 previous years to get an indication about the level of FCF the company can expect to make in the future. Remember that FCF is similar to what Warren Buffett calls the owner’s earnings, which is the money that is actually flowing back to you as a shareholder. BuffettsBooks.com has provided you with a tool that allows you to write a ticker, and automatically be taken to a site where you can copy paste the required data. FCF can change a lot from one year to the next dependent on the investment level, so it is important to look back in time.

  2. Estimating the short term growth rate can also be approached by an assisting tool similar to the one in step 1. While the past can be used as an indicator, it is very important to consider the growth/maturity state of the company. For very large companies you might only want to use a few percent, while smaller companies typically grow at a much larger pace.

  3. Determining the short run is interrelated with step 2. Many companies grow at a rapid pace for only a short period of time until they mature. For example, an IT company might be growing with double digit numbers for 5-10 years, followed by a more modest growth.

  4. Determining the discount rate is another way of asking which return you would require from a stock as an investor. While this might seem a bit redundant, it is a measure asking about how you deem the risk of the stock. For a new IT company you might require a larger return than for a large 10+ billion dollar net income company that has been around for over a century. At the final step of the calculation, BuffettsBooks.com has provided you with a simple solution if you want to leave the input at a generic 10% level.

  5. Determining the growth rate into perpetuity (forever) might seem like an impossible task. As a rule of thumb you are recommended to use 2-3%, which is simply the estimated inflation. It would be unrealistic to include a high growth rate forever.

  6. Input the number of shares outstanding. So far this calculation has been based on numbers for the whole company. This step takes the process down to a per share basis, making it comparable with the present share price of a single stock.

What has happened after all 6 steps is that the intrinsic value of a stock has been calculated for a single stock. This is done by discounting the estimated FCF that you, as a shareholder, would receive for holding the stock.

A few pointers that might be helpful:

Intrinsic value > market price = opportunity for a good bargain. Intrinsic value < market price = risk of overpaying for the stock

Compared to the intrinsic value calculator in chapter 21, this calculator can be recommended to be applied for:

  1. Valuating high growth companies
  2. Companies having a large number of share buy-backs.
  3. Companies having stock splits

If you’re interested in a more detailed description with an outline of how this calculator works, it can be found in the “Warren Buffett Accounting Book”. This book was written by us, Preston Pysh and Stig Brodersen, and it contains all formulas and definitions. If you have any specific questions about this calculator, please do not hesitate to ask Preston and Stig directly at: Ask The Investors