stock market lesson #2

Warren Buffett stock basics

Today I´m going to write about a easy way Warren Buffett used to pick stocks while working for Benjamin Graham. This is a fast to learn trick to determine stocks that are worth investigating and possibly investing.

3 Important terms are: Market Price, Earnings (Potential Returns) and Book Value (Margin of Safety)

Price/earnings – Ratio:

With the P/E- Ratio you can determine how high your potential Return is. For example a P/E- Ratio of 25 indicates a potential Return of 4%, assuming the company could turn all of the earnings into money thats actually realised to your pocket.

P/E Ratio =20 → Return= 5%

P/E Ratio =15 → Return= 6.6%

P/E Ratio =10 → Return= 10%

P/E Ratio = 5 → Return= 20%

What you should expect is, if the P/E Ratio is really low and the potential Return is high, your margin of safety is going to be worse.

Price to Book Value:

To show you what this means we´re doing a little example.

The Price of a company is $1000 and it´s Book Value is at $70.

→ P/BV- Ratio : $1000/$70 = 14.28

→ Every 14.28 dollars paid for this company has $1 in book value.

So you´re searching for a low P/BV- Ratio.

P/BV Ratio = 5 → Safety 20%

If you bought a company for $1000 and would need to end the business today you would get 20% of your investment back.

P/BV Ratio =3 → Safety 33%

P/BV Ratio =2 → Safety 50%

P/BV Ratio =1 → Safety 100%

P/BV Ratio =.7 → Safety 143%

Now what to do with this information ?

Warren Buffett and Benjamin Graham were focusing on finding a business with a P/E of 15 or lower and a P/BV of 1.5 or lower.

They decided to multiply those numbers together → 15*1.5=22.5

Therefore if P/E * P/BV < 22.5

then this company needed to be looked at.