We have covered a lot of grounds in the last few articles. Mostly we have learned about EPS, P/E ratio and Book value of a share. We have also learned where we can find these ratiosand how they can be calculated. In this article, you will learn how to quickly calculate the value of a stock. Before you go any further, I want to clarify one thing. This idea is useful to identify if a company is worth investigating in the first place. This will not explicitly say if a company’s stock is overvalued or undervalued in its entirety. This tool helps you save time from having to investigate a company only to figure out that you wasted your time trying to do so.
This beautiful idea was brought up by Benjamin Graham and Warren Buffet to help them quickly evaluate which companies they should investigate for investment potential. They came up with a quick mathematical tool and combined the ideas of EPS, Book Value, and P/E ratio to quickly calculate the value of a stock. From this article you will learn the following :
- Buffet’s 4 Rules of Investing (A summary)
- The mathematical tool to quickly calculate the value of a stock
- Patience and its importance while investing
- Individuality and its importance while investing
Buffet’s four rules of investments (A summary)
Despite being the richest man on the planet, Warren Buffet’s principles of investments are quite simple. He does nothing fancy and has four rules that he strictly follows before investing in any business.
First rule: The stock has to be stable and understandable
Most of the time, we are attracted to the most volatile and risky stocks. We all want to get rich quickly. To better understand this idea and ways to not fall into the trap of buying a risky and volatile stock, check out my last article.
Second rule: The stock must have a long term prospect
Whenever you buy into a share of a company, you have to ask yourself a crucial question. Is this company going to be still here in the next 30 years? If not, then why in your view, is this company worth an investment? People like warren buffet hardly if not ever invest in short term businesses that will die out in the next five years. Yes, this means that you might miss an opportunity to invest in technology-related stocks (like Google & Facebook e.t.c.)
History has shown that whenever it comes to buying a technology-related stock, we are very quick to judge that its a great opportunity and invest a lot of money. This is the reason for the 2001 .com bubble. Many technology startups die, and yes, some go on to become as massive as Google, Facebook or Uber. But you have to ask yourself a question as to why others that wanted to do the same thing failed so miserably? This is not to say that you should never invest in technology-related stocks but that you have to be very vigilant when it comes to an understanding of the future sustainability of that business. And this idea holds for any other business. It is just that we have a disposition when it comes to new and exciting. And a strict rule that you can follow to avoid this bias is to never buy into a company just because it is a cool idea or a cool business and always look at numbers before making your decision.
Third Rule: A business must be managed by vigilant leaders
This rule is probably a tough one to follow for many. If you don’t have a lot of money or know influential people in high places, it will be particularly hard for you to get into a room with all the board of directors of a company and to check their competency individually. But there is a way you can do it even if you are a mortal being. The method is to check the company’s financial statements and look at how well that company manages its debt. If a company is taking on too much debt and the earnings are not indicative of that debt, then you can assume the company has lousy management. Whenever you see an enormous debt to equity ratio (A topic I will discuss in a future post), the smart option is to run away from that company.
Fourth rule: Always buy an undervalued stock
This is a very straight forward Rule. You should never overpay for a stock. And below we will discuss how you can quickly calculate the value of a stock. It’s a mathematical tool that will help you figure out if a company is worth further investigation.
The mathematical tool to quickly calculate the value of a stock
During the pre-internet age, it was tough to identify which companies are worth investigating. There were no online databases to quickly search for a company’s finances. People had to go through a massive book of stocks and look at companies’ finances manually. As you can assume, that was a very tedious process. Hence Benjamin Graham and Warren Buffet (a student of Graham at the time) combined the ideas of EPS, P/E ratio, and BV and came up with a mathematical tool. This tool helped them to quickly calculate the value of a stock. This will then help them to quickly identify if a company is worth further investigation. To understand this idea, let us define the Market price, earnings, and book value, as shown in the figure.
Revisiting the P/E ratio
From the last article, we have a clear idea of what the P/E ratio represents. However, the P/E ratio also gives you the amount of return that you can expect. For, e.g. If the P/E ratio is 5, then you can expect a 20% return the very next year. Similarly, if the P/E ratio is 25, then it means you can expect a 4% return the very next year. You can see in the figure above how your returns might change as the value of P/E increases or decreases.
Defining the P/BV ratio
Similarly, let us explain somewhat of a new term which is the Price to Book Value ratio. It is calculated as the Market price (Rs.10) divided by the Book value (Rs. 0.7). To understand what this ratio implies, let us look at an example. If the P/Bv ratio is said to be 14.3, then it merely means that for every “Rs 14.3 you spend buying into a business you will have Rs.1 as equity in that business”. Hence the lower the P/BV ratio, the larger is your margin of safety as you can see in the figure above.
Note: If the P/BV ratio is too low it could also indicate that the company has really low earnings.
Combining P/E and P/BV ratio: Graham Number
Warren Buffet and Benjamin Graham came up with this brilliant idea, and they did that by defining a certain threshold for the two ratios. They started to search for companies with a P/E ratio of less than 15 and the P/BV ratio lower than 1.5. If you take a product of those values than you get 22.5. Hence they started to look for companies with P/E*P/BV less than 22.5. Anything above that threshold was considered to be overvalued and not worth further investigation. Hence you can use this principle and come up with your limit and call it whatever you want to.
In our example, with the fruit business, the number turned out to be 5*14.3=71.5. Hence, from this, we can quickly know that the stock is massively overvalued.
Patience and its importance while investing
Patience is a fundamental virtue that needs to be present in an investor and not only in an intellectual sense. Patience can be developed, and we, as investors, should strive to be more patient with our investments. This is to say that we cannot afford to be emotional and take impulsive decisions every time the market is doing good or bad. I think to be a good investor, you have to be able to trust your judgment and stick to that judgment, especially during the hard times. Anytime you find an “investment” that promises massive returns, it is better to run away. If something is too good to be true, then it probably is.
There is a famous saying in the investment realm:
“Pigs get fat, and Hogs get Slaughtered”
Here pigs are those investors who are happy with making an average 10-15% return on their investments. And this framework will help you in the long run. This is because, in the short term, it is not important what the company is doing. Prices are defined by the investors who day trade. But in the long run, the market price of the company is dictated by how well the company is doing financially and socially.
So, don’t be a hog who chases after quick returns and thinks about doubling or tripling his money in the next three to four months. With this framework, You will fail miserably in the long run. This is because you can only flip a coin so many times to get consecutive heads.
Individuality and its importance while investing
Individuality is an idea that needs to be heavily internalized by an investor. Always make your own decisions when it comes to investing in anything. Never blame others for the choices you make. Use the tools provided and make your personal decision based on your analysis. When the market is doing good everyone says it’s the right time to invest because How can things turn bad when good things are happening. We think when the market is doing good, it will last forever. Hence Never follow what everyone else is doing. Stay away from the herd mentality, and you will be fine in the long run. Make your own decision and never blame the outcome of that decision to anyone.
- Here we learned about Buffet’s Four rules of investing
- First rule: The stock has to be stable and understandable
- Second rule: The stock must have a long term prospect
- Third Rule: A business must be managed by vigilant leaders
- Fourth rule: Always buy an undervalued stock
- Product of P/E and P/BV can quickly help you calculate the value of a stock and to identify if a company’s stock is worth further investigation.
- Always be a PIG and be Patient with your investments.
- Trust the decisions you make and never blame others. i.e never make a speculative decision based on what he/she said about a company.
Last articles on Value Investing