by Preston Pysh and Stig Brodersen
Table of Contents
Preface How to use this book
Chapter 1 How to Look at the Stock Market
Mr. Market and bubbles in the market
Good news! The market is dropping
Why stocks will make you wealthy
Chapter 2 Concepts Every Investor Should Know
Chapter 3 A Brief Introduction to Financial Statements
The income statement
The balance sheet
The cash flow statement
Chapter 4 The Principles and Rules of Value Investing
Principle 1—Vigilant leaders
Principle 2—A company must have long-term prospects
Principle 3—A company must be stable and understandable
Principle 4—Buy at attractive prices
Chapter 5 Financial Statements and the Stock Investor
Why are financial statements important to the stock investor?
Accounting basics at a glance
Chapter 6 Income Statement in Detail
Introduction to the income statement
Looking at the income statement with fresh eyes
The single lines in the income statement
A final review of the income statement
Ratio analysis for the income statement
Chapter 7 Balance Sheet in Detail
Introduction to the balance sheet
Ratio analysis for the balance sheet
Chapter 8 Cash Flow Statement in Detail
Introduction to the cash flow statement
Cash flow from operating activities (lines 1 – 6):
Cash generated from investing activities (lines 7 – 11)
Cash generated from financing activities (lines 12 – 17)
Arriving at the net change in cash
Key ratio analysis for the cash flow statement
How was the BuffettsBooks.com Intrinsic Value Calculator derived?
Accounting for a steady and growing dividend payment
Accounting for growth in treasury stock
Using the calculator for high-growth companies
How to use this book
This book is the result of an evolving idea: everyday investors should not need a master’s in finance to understand the fundamentals of Warren Buffett’s investing approach. In 2012, we wrote a book titled Warren Buffett’s Three Favorite Books. The book was written for amateur investors so they could understand the very basic and fundamental ideas around Warren Buffett’s investing approach.
This book, however, takes investing to the next step—it teaches essential accounting terminology and techniques that serious stock investors need to know. The first four chapters of this book teach you how to think about the stock market, how to select and value stocks. Only limited accounting skills or knowledge will be required for this. If you want to dig further into corporate accounting, the last four chapters are where you will have a chance to get your hands dirty. This is where we will discuss the individual lines of accounting found on the three financial statements. Since this book’s principles are based on the ideas of a few brilliant people, let’s start with a brief introduction:
Warren Buffett (1930 – )
Starting out from nothing, Warren Buffett is now perceived as the greatest stock market investor of all time. His current net worth is in excess of $60 billion. His fortune has been built on a sound and consistent investment approach—which we will outline throughout this book. He is the CEO of a company called Berkshire Hathaway. Berkshire is an American conglomerate holding company, of which he is the largest shareholder. More than 99% of his net worth has been pledged to philanthropy.
How to Look at the Stock Market
Value investors view the stock market differently than other investors. They don’t believe that the stock market consists of stocks. They know that the stock market consists of real companies. That little difference changes everything. It also explains why value investors consistently beat the stock market year after year.
In this chapter, you will learn how to think differently about the stock market. By thinking differently, you will have a distinct and unique advantage that will lead to growth, reduce risk, and create less stress. You will learn why it is good when stock prices drop, and why the wise stock investor will grow wealthy over time.
Mr. Market and bubbles in the market
Have you met Mr. Market? If you have ever traded on the stock exchange, you have met him. If you have listened to financial news, you have heard about him for sure. Mr. Market is a fictitious person about whom the founder of value investing, Professor Benjamin Graham, taught to his class at Columbia University in the 1950s. Perhaps you have heard of Graham? If not, I’m sure you will have heard of one of his brilliant students: his name is Warren Buffett and he is the most successful stock investor in history.
Mr. Market is a very important person to familiarize yourself with if you are serious about stock investing. Every day he comes by to visit you. When he arrives, you can buy or sell high- and/or low-quality companies. It is always nice to get a visit from Mr. Market. He doesn’t get offended easily. You can look at his companies as much as you want—every day if you wish—and you don’t have to buy or sell anything. You can wait as long as you would like. The best part about Mr. Market is that you can ignore him for years, yet he will keep coming back every day with new offers.
Sometimes when Mr. Market arrives, he is in a good mood. When this happens, Mr. Market has a lot of customers and the prices are high for all of his products —both the high-quality and low-quality companies. The next day when Mr. Market visits, there might be very few customers. As one might expect, Mr. Market will not be in a good mood. On these days, the companies Mr. Market is selling are on sale; therefore, the price for the exact same company is cheaper. Yes, you probably have guessed what we are talking about. We are talking about the stock market. The stock market moves up and down every day. Some may argue that there is always a reason for stock price fluctuations. They think the current price always reflects the true value of the company. This idea is especially popular within academia.
Value investors like Warren Buffett and Benjamin Graham strongly disagree. They believe the stock market moves in the short term due to emotions and in the long term due to value. Mr. Market may be a fictitious character, but he’s a symbol of the emotional psychology the stock market follows in the short term. There is good reason to believe that Warren Buffett is right: he’s accumulated over 60 billion dollars in personal wealth using value investing.
For many investors, the stock market remains a puzzle. They see a lot of different prices that move up and down. They base their actions on hope with the expectation that they can buy cheap and sell high. Now, you’ll notice I referred to them as investors. I would like to withdraw that. In my humble opinion, these people are traders. The world has always had a lot of traders. Five hundred years ago, Europeans sailed to the new world to buy tobacco and sell it for a higher price back home. When you are shopping for groceries, you are buying milk at a higher price than the store bought it for. Trading is a technique. It does not matter whether it is tobacco, milk or stocks.