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LESSON SUMMARY
In this lesson we learn that Warren Buffett wants to invest in companies that are both stable and understandable. You can get a very good indication of this by looking at the key ratios for the previous 10 years for the company. This video shows you how and where you can find them, and also includes the following points:
1) Why is stability important for a stock pick: Warren Buffett always does a valuation before he buys a stock. It’s really hard to do a valid valuation if you don’t know where the business is tomorrow, and how much money it can expect to be making. Therefore he always makes sure only to buy into stable companies with proven track records.
2) Why is it important to understand the business model of your stock pick: You might be wondering how many things we use in our daily life and not fully understand. Do you really understand how a car works? No, not really, right? But you still drive to work every day. The reason why Warren Buffet wants to have detailed information about how a business makes money is because he can either add or eliminate his position in a stock. He makes that decision based on how he thinks the business is performing and where it’s heading, and he can only know this if he fully understands the business.
LESSON TRANSCRIPT
Before everything else, you need to refer to the video as you read this in order to fully understand this lesson. Let’s start.
STABLE BUSINESS
We have a person named Andrew, and we’ve been tracking Andrew’s equity, earnings, and debts for the last 10 years from 2002 to 2012. We’ll assess Andrew on each of the areas – equity, earnings, and debts – that he’s managed over the last 10 years for himself. This is not a company. This is just Andrew.
Andrew’s equity over the last 10 years had ups and downs, but generally, it moved in the upward direction. The numbers on the left and the graph on the right are his earnings. However, in the last 5 years, it’s been steady. His debt is all over the place – both high and low – and is at the same level which is high compared to how much equity he has.
The point here is if we were going to predict how much equity Andrew would have in the year 2022, it might be a little hard for us to determine that based on his past performance. Now that doesn’t mean in the future he could just start having very sustained equity growth. He could have very sustained earnings every year. That can happen, but most likely that won’t happen. This type of person will continue to live this style and he’s going to have his ups and downs most likely in the future which makes predicting how much he’ll be worth because that’s really what this is. His equity is his net worth. If he would liquidate or he would die, Andrews’ assets would be added and subtracted from his liabilities that would be his equity. Predicting how much equity he would have 10 years from now would be difficult based on his previous lifestyle.
Let’s look at a different person named Linda. Linda lives a completely different way than Andrew. Her equity grows very steadily every single year, almost by the same margin and it’s a very linear graph. When we estimate how much equity she’d be worth 10 years from now, everyone would agree that would be a lot easier compared to Andrew.
As we look at these two people, the takeaway here is that businesses are managed just like individual people. The business that we want to find and invest in is that business that is very steady and predictable because when we try to figure out the intrinsic value of a business, we’re adding up all the cash that we can take out of the business over a 10-year period. When walking that assessment, it’s very difficult to do when you have a business that moves like Andrew as opposed to a business that moves like Linda.
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 point. Andrew could be worth as much as Linda in the future, but again, Andrew is unpredictable. Linda has a much better idea of where she’s going to be. That predicts the value where some things are going to be in the future. That’s a risk. We’re trying to minimize the risk while still having some decent returns.
DETERMINING INTRINSIC VALUE
Now we look at Disney’s and Sirius Radio’s equity, debt to equity, and earnings, and see how it’s progressed over the last 10 years. We will compare.
Go to MSN money again and first study Sirius Radio. Enter S-I-R-I. It takes us to the top-level page where it gives us all the information. At the top is a 10-year summary; click that. Look at the book value per share and see how it’s changed for Sirius Radio over the last 10 years.
We’re looking at the equity of the business and how it’s hanging over the 10-year period. When we look at Sirius, back in 2002, it was worth $7.33 a share, and then the next year it went down to $1.16. You see that progression and how that number really dipped an enormous amount? In the last 3 years, they have been slowly making some growth in their equity.
The next number is from Warren Buffett’s first rule about the debt to equity ratio. This gives you the debt to equity ratio for the average debt to equity ratio for each year. Remember, we want to find a business that has a debt to equity below .5. Sirius Radio has got very high numbers. That’s something you really want to avoid if you were going to invest in this company.
As far as the earnings per share which you remember from course 1 unit 1 lesson 2, that’s essentially your profit per share. To find that, go to the left of the screen where it says the 10-year summary. Click that and it will show the EPS. This is the trend for the last 10 years. The earning on Sirius Radio is -$6 a share, -$.38 a share, -$.57 a share, and it goes only recently in the last 2 years where they have had positive earnings per share with $.1 and $.7. That’s the trend of this company. Now I will show you how that would look on a graph if we plotted all the numbers.
I’ve plotted out 2 of the numbers – equity and debt to equity ratio. Equity is not a good trend. We want it going in a positive direction and not in a negative direction. Not only do you want to be going in a positive direction, but you want that to be really linear. The more linear, the more predictable it is to assess how much it will grow in 10 years. The debt to equity Sirius is unfortunately so high in 2008 that we can’t even see how those values were fluctuating that much for all the other years. To go from 15.5 in 2010 down to 4.28 in 2011, those are enormous changes. That’s something to avoid.
Predicting the intrinsic value of the company is exceptionally hard to do because in the past the company has been all over the place. We can’t come up with an intelligent estimate of what we think this company would do over the next 10 years. If I were to calculate the intrinsic value of Sirius, I would stop right here right now.
Let’s take a look at Walt Disney Company. Type D-I-S. Just like we did before, scroll down and go to the key ratios tab and go to the 10-year summary. It takes us to this page. The book value, which is the equity per share, in 2002 was $11 and even goes up to $13. This nice steady trend is exactly what we’re looking for when finding a business.
Their debt to equity is really good. Disney has generally managed their debt below .5, which is exactly the number that we want to see.
Click again on the 10-year summary and now look at the earnings per share. This is generally trending. It starts off at $.60 10 years ago, and now it’s up to $2.50. It keeps increasing. At a minimum, if the earnings are consistent, for example, it’s $2.50 for 10 years, that’s wonderful. When you see it growing, even better.
UNDERSTANDABLE BUSINESS
Now put all these numbers on a chart to graphically see what those numbers are doing. On the left is the equity and on the right is a nice linear graph over the last 10 years. They’re growing that equity. When you have a company that’s growing their equity nice and consistent, that will reflect in the market price. The market price will trend exactly with the equity.
Now the debt. Back in the early 2000s, Disney had a little bit above .5, but in the last 5 years, they maintained it below .5 and have been trading in a downward direction since. That’s obviously really good as well. If we’re looking at a stable company, it’s not necessarily the company you should buy, because there’s still a lot to figure out, likewise worth.
However, if we’re trying to predict where the company will be in 10 years, Disney is going to be so much easier to predict than a company like Sirius. In 10 years form, Sirius might be the best company after 10 years and Disney is vice versa, but we are trying to predict which company is going to be where 10 years from now based on this chart and numbers. We can see that Disney is much more stable and calculable than Sirius radio.
In this rule, we not only want to have a stable business, but we want a business that we understand. I’ve never really understood the Sirius Radio thing. My friends swear by this company and they love the service, but for me, it’s not something that I really care for.
For Disney, I’ve been there a few times and their products are impressive. It’s a viable product and I’ll be there for years to come.
In this lesson, students learned the importance of stability. The most important reason why we must pick a stable stock is that we’re unable to accurately predict the growth of the earnings without stability. If a company has an unstable past, it is possible that its future will become stable – it’s just less likely than a company that’s already demonstrated those attributes. I like to think that companies perform and act like individual people you might know. Some people are very conservative and grow their assets at a nice and controlled pace. Others do not. As you look at that example, it becomes obvious that the person that manages their finances conservatively will be easier to predict future performance. This is very important as we move to the next lesson and learn to calculate the intrinsic value of a stock.
LESSON VOCABULARY
Equity
You can think about equity as the net worth. So if a company has to liquidate according to the value in the financial statement this is the cash that should be left. For your personal finances, you can think of equity as the money you would have left if you sold everything you owned and paid off your debt.
Stable Business
A business is often considered stable if the track record for key ratios like book value per share, EPS, and debt is trending consistently for 10 years. Where this is no guarantee for the future is a strong indication.
Understandable Business
Everybody has some knowledge about some products or services. Perhaps because they use them every day as leisure or perhaps because they have special knowledge from their day job. Investing in a business that you understand gives you a strong advantage in determining when to buy, hold, and sell stocks.
