Over the last sixty years, the world has come to know one of the greatest stock investors of all time - Warren Buffett. Although a lot is known about what stocks Warren Buffett owns, few understand how he picks them. Hopefully, this little guide will help.
The first thing a person must understand to invest like Warren Buffett is that owning one stock is no different then owning an entire business. For example, if you own 1 share of Wal-Mart, you will make the exact same return, relatively speaking, if you owned all the shares. You see, Warren Buffett looks at the ownership of 1 share as if it was a miniature business. To demonstrate this idea, let’s image that we opened a game of monopoly. As you probably remember, there are plastic hotels used to play the game. Now, Imagine that you place one of these plastic hotels down on a desk in front of you. As you look at that plastic building, imagine that it’s a miniature business; let’s call the business Wal-Mart Mini. Since the business is so small, it’s only worth $75. When you buy this miniature business for $75, you can expect to make a profit every year. For this particular business, it makes a profit of $4.65 each year. As you can see, if you spend $75 purchasing this tiny company, you’ll most likely make a 6.2% return on your money. Return equals the profit ($4.65) divided by the cost to own the business ($75): $4.65/$75 =.062
Now the above scenario makes a lot of sense because it’s in terms that anyone can understand. Image how complicated things sound when I say the Market Cap for Wal-Mart is 251 billion dollars and the net income is 15.6 billion dollars - Yuk! Although the previous sentence makes our heads hurt, I just describe the same scenario as the previous paragraph. You see, when Warren Buffett buys stock in a company, he values 1 share like he’s buying the whole thing. Going back to our monopoly game scenario, we would need to have 3.4 billion plastic building on our desk in order to symbolically represent the entire Wal-Mart Business. The key point to take away from this is it doesn’t matter if you can buy 1 share or every share, the intrinsic value (or true value) of the shares doesn’t change based off the number you own. The price you pay versus the expected profit (or earnings) is what matters.
In the second paragraph, I stated that the price of the business was $75. If you were to look up the market price of Wal-Mart on the New York Stock Exchange in August of 2012, you would find $75 to be the trading price. If you looked up the EPS (Earning per Share), it was $4.65. The EPS is the profit - this number is really important to understand. One of the quickest ways to invest like Warren Buffett is to always compare the EPS to the Market Price. This ratio is called the P/E ratio. To calculate this ratio, simply divided the market Price ($75) by the EPS ($4.65). This ratio shows you how much money you are paying in order to earn one dollar in a year’s time. For Wal-Mart, the P/E ratio is 16.13. This means that for every $16.13 you spending buying stock in Wal-Mart, you can expect $1 in return a year later. As you can quickly see, a company with a low P/E means you’re paying less money in order to earn the same annual dollar.
Although this article describes the bare-bone-basics to Warren Buffett’s investing techniques, the foundation is incredibly important. An investor can never implement Warren Buffett’s complex ideas without first understanding this essential concept: When you buy stock, you’re actually owning a business.