The Buffett Way
Contents
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INTRO
When it comes to investing, the price you pay is critical in many respects. You can read 50 annual reports, spend 100+ hours on research, know all the numbers, and you’ll still fail. Why? Because of the price you paid...or overpaid.
Legendary investor Warren Buffett constantly reminds us of 2 general key steps toward successful investing. First of all, seek to identify companies with a durable competitive advantages, those that consistently generate above-average returns. And secondly, aim to buy into those investment opportunities at attractive prices.
Based on my experience, 9 out of 10 investors don’t know how to find the right buy point. Keep reading and I’ll teach you.
Let’s start with what not to do.
How To Fail
While the price you pay will ultimately drive your returns, don't overly focus on price as a barometer for finding good stock opportunities. The price alone won't cut it, and by all means, don't try to time the Market.
Ever heard of price myopic? Price myopic is extremely common among investors in the stock market. If the price of a particular stock is going up, we assume good things are happening. If the price starts to go down, on the other hand, we assume something bad is happening, and we tend to act accordingly by selling.
Evaluating price performance over short periods of time is a very poor mental habit. Stock price should not be a benchmark for measuring performance. If you owned a business with no daily stock quotes (such as a privately held business), you would determine the worth of the business by honing in on key aspects of the business: growth in earnings, the increase in return on capital, quality of management, or the improvement in operating margins.
So instead, be sure to focus primarily on the underlying economics of the business. That's what dictates the worth of the company and its ability to produce cash flows well into the future. But aim to buy great opportunities at attractive prices to support strong returns on investment (ROI).
What matters is giving investment opportunities thoughtful research and analysis of the underlying business, not the short-term movements of it's stock price. But the stock price volatility of the Market can create opportunities to buy into solid businesses with strong long-term economics at discounted prices. You certainly don't want to pay just any price for a business, not even a well-performing one.
“Learn from the mistakes of others. You can't live long enough to make them all yourself.”
― Eleanor Roosevelt
Here are a few examples of what not to do.
- Buy just because the stock is going up.
- Buy just because the stock has dipped and is going down.
- Invest based on your friend's advice.
- Dump your money into the next meme stock.
- Buy without any research.
- Conclude your research and overpay.
Weirdly, the last one appears to be the most common. And I’m here to fix that, so let’s learn how to find the right price.
How To Put A Price Tag On A Stock
Buffett will only invest in a company when he can get it at a low enough price - which he determines by projecting an annual compounding rate of return for the investment which he feels meets his required rate of return. Read more in this piece from Yahoo Finance - Warren Buffett on Why It's Important to Pay the Right Price
Let me simplify this as much as possible. The value of a stock depends on the cash flow it's expected to make in the future. But because money loses value over time, we have to adjust for that by discounting those future earnings to present value.
Ratios (like the P/E) don’t truly tell you anything valuable. So, we need better methods, and I know of one in particular that is well-suited.
Discounted Cash Flow Method
The Discounted Cash Flow (DCF) method calculates the present value of a company's future cash flows to determine its worth today. This is the best method for gaining an assessment of a company's intrinsic value.
Here's an example: Let's say you expect a lemonade stand to generate free cash flows of $100 next year. You also expect it to make $110 the following year and $120 the year after that. If you discount these cash flows by 10% per year (to account for risk and time value of money), the DCF value of the lemonade stand today would be around $290.
So, if the lemonade stand was trading below $290, it would make sense to buy it. The only true way to figure out the right price is with the DCF method. I suggest you run the numbers manually because online calculators can’t really be trusted.
But just in case you ever want to try your luck: Guru Focus DCF Calculator Tool
Now that we have our number, let’s move forward.
The Final Step
All that remains now, is to compare your DCF number (your assessed intrinsic value of the company) to the stock price. The best way to reduce risk is by having a thorough understanding of the business, its operations, and confidence in its management. To aid with reducing risk further, buy stocks at prices that allow a margin of safety. Read more on margin of safety in a prior write-up found here: Margin of Safety: Why It's Necessary and How to Estimate It.
Overall, take a look at the DCF number you've established:
If it’s below, you think.
If it’s above, you don’t buy.
If it’s way below, you buy.
That’s because now, you also have a margin of safety in case you made a mistake with the numbers. Don't try to time the market though. Rather, always be on the lookout for companies with excellent long-term business economics that find themselves trading at a price believed to be well below their intrinsic value. If an opportunity you're evaluating isn't selling at an attractive price, move on to the next potential opportunity and keep a lookout for any downward movements in the price of the stock assuming fundamentals remain strong.
Conclusion
Remember, paying too much for a stock can still hurt you, even with research. But, pay a low enough price for the right business and the returns you earn will be spectacular.
“Price is what you pay. Value is what you get. It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” -Warren Buffett
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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions. I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.
