## BUFFETTS BOOKS ACADEMY: INTERMEDIATE COURSE

**LESSON 20: WARREN BUFFETT’S 3RD RULE – STABLE AND UNDERSTANDABLE**

## LESSON OBJECTIVES

- Understand why stability is important for determining the intrinsic value.
- Understand why it’s important to invest in a company that you understand.

## LESSON SUMMARY

In this lesson we will look at Warren Buffett’s third rule, and why he thinks it is important that his stock picks are both stable and understandable.

**Stable Business**

Imagine a young investor – let’s call him Andrew. He has a lot of energy and many great ideas that he all thinks should have an honest try. When tracking his equity, earnings, and debt over a 10 year period it can be observed that his track record is all over the place. There is no stability at all to see. In other words: It is impossible to know how he is financially 10 years from now. This does not mean that he can have stable earnings in the next 10 years, but everything else equal, it would probably not be wise to think that we can predict the financial future for him.

Imagine another investor – let’s call her Linda. She is very considerate in her in her investing approach and makes a thorough research every time she buys a new stock. We observe that the development of her equity is very steady and increasing. In any case we can say that it is less risky to predict where Linda is in 10 years financially than Andrew.

Beware that this is not the same as saying that there is a certainty that stable increase in equity will continue. Nor is it the same as saying that there is a certainty that volatile numbers can be stable or be very profitable in the future. The take away for these examples is that companies work just the same way as humans. Stable companies tend to remain stable, and unstable companies tend to remain less stable in the future. When it is more difficult to predict and value a company this is equivalent to taking on risk.

When analyzing a new stock pick it is highly recommendable to check out the 10-year trend for a number of key ratios. All providers like MSN Money, Morningstar, and Yahoo finance provide key ratios back a number of years. To get you a better overview of the stability and trend of the most important key ratios BuffettsBooks.com has provided you with a free tool. You can find it at the end of this summary:

When looking at the key ratios for the last 10 years you want the book value per share (equity) to steadily increase. You want the debt/equity to be below 0.5 and steady or declining, and you want your EPS to be growing or at least consistent. Again, this is no guarantee of the future, but it is a strong indication whether the company at least in the future has proven to have a good track record.

**Understandable Business**

Before picking a stock it is a good idea to ask yourself if you understand it. If you understand a company, you would typically also have a good idea, if a change in strategy or products will have a negative or positive effect on the earnings. That way you can as an investor either buy, hold or sell your stock in the company accordingly to the development.

Peter Lynch, known as the best mutual fund manager in the world averaged 29% in annual return between 1977 and 1990. Just like Warren Buffett he is a big spokesperson for only investing in companies that you really know. His philosophy is that since you are spending your time on products and service you really like, where not also profit from that knowledge that you have about them. Sold in more than 1 million copies his book One Up Wall Street is a strong insight into how to capitalize on your own ideas in the stock market, and why your knowledge is just, if not even more, powerful than Wall Street.

*Related Resource: Podcast discussion on **Warren Buffett’s Rules to Stock Investing.*

## STABILITY GRAPHER

Need help finding the values below? Input the ticket here: | ||

Copy and paste the data from Morningstar into these cells then click the "Create Printable Graphic" button below the table to view the stability plots of the data. A new browser window will open with a pre-formated printable page.

Year -10 | Year -9 | Year -8 | Year -7 | Year -6 | Year -5 | Year -4 | Year -3 | Year -2 | Year -1 | ||
---|---|---|---|---|---|---|---|---|---|---|---|

EPS | |||||||||||

Dividend | |||||||||||

Book Value | |||||||||||

Return on Equity | |||||||||||

Current Ratio | |||||||||||

Debt/Equity |

## NEW 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 of 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 is determining when to buy, hold, and sell stocks.

## 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.

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 off of 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 subtracting at his liabilities that would be his equity. Predicting how much equity he would have 10 years from now would be difficult based off of 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 this two people, the take away 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 opposed to a business that moves like Linda.

Just because business has volatile numbers doesn’t mean it won’t a 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 where she’s going to be. That predicts the value where some things are going to be in the future. That’s risk. We’re trying to minimize the risk while still having some decent returns.

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 imfortaion. 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 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 debt to equity ratio. This gives you the debt to equity ratio for the average of the debt to equity ratio for each year. Remember, we want to find a business that has a debt toequrity 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 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 a 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. The equity is not a good trend. We want it going in a positive direction and not into 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 sirus is unfortunately so high in 2008 that that we can’t even see how those values were fluctuating that much for all the other years. To go from a 15.5 in 2010 down to a 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’s starts off at $.60 10 years ago, and now it’s up to $2.50. It keeps increasing. At a minimum, if the earnings is consistent, for example it’s $2.50 for 10 years, that’s wonderful. When you see it growing, even better.

Now put all this 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 of .5, but in the last 5 years, they maintained it below .5 and has 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 year