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Warren Buffett is one of the most quoted investors in history, both for his sage wisdom and financial success. One of his recommendations for investors is to think of stocks as a business.
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Berkshire Hathaway’s billionaire CEO said in a letter to shareholders in 2023 that he and Vice Chairman Charlie Munger “are not stock pickers. We are not stock pickers.” We are business pickers. ”
To Buffett, stocks are more than just faceless entities whose prices rise and fall on the public market. Rather, they are economic agents whose profits drive stock prices. So how does Buffett value businesses? And how can you learn how to do it yourself? Read more about “The Oracle of Omaha.”
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Buffett’s approach to investing
Buffett learned to value stocks based on the principles of his mentor, legendary value investor Benjamin Graham. Although his investment process is more complex (more on that below), Buffett essentially believes in acquiring undervalued companies based on his own analysis of their current and future business prospects. . When he finds a company he likes, he typically bets heavily on it and holds it for the long term.
At Berkshire Hathaway’s 2023 shareholder meeting, he summed up his investment strategy in one phrase: “What gives us opportunities is when other people are doing stupid things.”
He continued: “I would say that in the 58 years that we’ve been running Berkshire, the number of people doing stupid things has increased significantly. They’re doing big stupid things.”
When investors do “stupid things,” as Buffett puts it, they end up overvaluing some companies and undervaluing others. This presents an opportunity for investors like Buffett, who has lots of cash and patience, to take advantage of these failures.
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How Buffett evaluates his business
As analyzed in the Graziadio Business Review, Buffett is able to determine a company’s intrinsic value from a variety of inputs and compare it to its current market value. Buffett uses accounting data such as revenue, net income, book value, earnings per share, dividends per share, and total shares outstanding to calculate expected return on equity and book value per share growth rate. To do. Next, he attempts to determine the expected return on the investment over the next 10 years. If it is lacking, he will not take action on it.
But for the average investor, the math behind Buffett’s strategy can be overwhelming. This is one of the reasons Mr. Buffett is so popular. Mr. Buffett is able to break down his investment philosophy into quotable and easy to understand principles.
Washington State University’s Carson School of Management has created an infographic summarizing Buffett’s three fundamental investment philosophies, based on quotes from Buffett himself.
Here we briefly explain each.
Acquire a business with a “hori”
An economic moat protects your business from competitors. There are many ways a company can build a defensive moat, from developing a product that no one else is selling to simply offering a product or service that’s better than others. This moat must be permanent. This means that it will not be affected rapidly by changes in the industry.
As Buffett said in a letter to shareholders in 2007, “A moat that must be continually rebuilt will eventually have no moat at all.”
Buy quality business at reduced prices
This is perhaps the most famous explanation of how Buffett invests. As a value investor, he never overpays for a stock. This is why he tends to act immediately during major market corrections, rather than buying during bull markets. As Buffett himself says, “I like to buy quality products when prices are low, whether it’s socks or stocks.”
invest in what you know
Buffett famously avoids acquiring companies he doesn’t personally understand. He admits he missed out on some big opportunities, such as the chance to invest in pre-IPO Google, but he fully understands the risks involved in acquiring a company he doesn’t know how to value.
“I get into enough trouble thinking I know something,” he famously quipped. “Why on earth would you take a long or short position based on something you know nothing about?”
How to apply these principles to your own investments
At its simplest, Buffett says investors should stick to what they know and buy durable, high-quality companies when they’re trading cheap. Determining when a company is truly undervalued requires performing some analysis, but it’s a worthwhile endeavor.
For example, just because a company’s stock price has fallen does not necessarily mean that the company is worth more. But if you look at the company behind the stock price, you’re more likely to be able to make that determination.
As Buffett says, “If your business does well, the stock price will eventually follow.”
If you want to invest like Buffett, take the time to understand the business behind a stock, rather than chasing it and thinking of it as a separate entity.
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This article originally appeared on GOBankingRates.com: How to understand the business behind stocks like Warren Buffett
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