How To Understand the Business Behind a Stock — Like Warren Buffett Does
Written by
John Csiszar
Edited by
Chris Cluff
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Warren Buffett is one of the most quotable investors in history, due both to his pithy wisdom and his financial success. One of his recommendations for investors is that they think of stocks as businesses.
In his 2023 letter to shareholders, the billionaire CEO of Berkshire Hathaway said he and vice chairman Charlie Munger “are not stock pickers; we are business pickers.”
To Buffett, stocks aren’t just faceless entities that rise and fall in price on the open market. Rather, they are economic entities whose profits drive their share prices. So, how does Buffett value businesses, and how can you learn to do it yourself? Read on to learn more from the “Oracle of Omaha.”
How Buffett Approaches 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 buying companies that are undervalued, based on his own analysis of their current and future business prospects. Once he finds a company he likes, he generally makes a sizable bet on it and holds it for the long haul.
At the 2023 Berkshire Hathaway shareholder meeting, he summarized his investment strategy in a nutshell: “What gives you opportunities is other people doing dumb things.”
He went on to say, “In the 58 years we’ve been running Berkshire, I would say there’s been a great increase in the number of people doing dumb things, and they do big dumb things.”
When investors do “dumb things,” as Buffett puts it, they overvalue some companies and undervalue others. This offers investors such as Buffett, who have a lot of cash on hand and a lot of patience, the opportunity to take advantage of these mistakes.
How Buffett Values Businesses
As broken down by the Graziadio Business Review, Buffett determines the intrinsic value of a firm — which he can then compare with the current market value — from a variety of inputs. Using accounting data such as revenue, net income, book value, earnings per share, dividends per share and total shares outstanding, Buffett calculates the expected return on equity capital and the growth rate of book value per share. He then attempts to determine the investment’s expected return over the next 10 years; if it comes up short, he won’t make a move on it.
For the average investor, however, the mathematics behind Buffett’s strategy can be overwhelming. This is one of the reasons Buffett is so popular: He’s able to break down his investment philosophy into quotable, easy-to-understand principles.
The Carson College of Business at Washington State University assembled an infographic summarizing three of Buffett’s basic investment philosophies, based on the billionaire’s own quotes:
- Buy businesses with “moats”
- Buy quality businesses when they are marked down
- Invest in what you know
Here’s a quick look at each of these.
Buy Businesses With ‘Moats’
An economic moat protects a business from competitors. There are a number of ways for a company to develop a defensive moat, from creating a product no one else sells to offering a product or service that is simply better than others. This moat should be enduring, meaning they won’t be rapidly affected by change in an industry.
As Buffett said in his 2007 letter to shareholders, “A moat that must be continually rebuilt will eventually be no moat at all.”
Buy Quality Businesses When They Are Marked Down
This is perhaps Buffett’s most famous explanation of how he invests. As a value investor, he will never overpay for a stock. This is why he tends to spring to action during major market corrections, rather than buying in the midst of a bull market. As Buffett himself put it, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
Invest in What You Know
Buffett famously avoids buying businesses that he doesn’t personally understand. While he admits he has missed out on some big opportunities — such as the chance to invest in Google before its IPO — he fully understands the risk involved in buying companies that he doesn’t know how to value.
“I get into enough trouble with things I think I know something about,” he famously quipped. “Why in the world should I take a long or short position in something I don’t know anything about?”
How You Can Apply These Principles to Your Own Investing
In the simplest terms, Buffett says investors should stick to what they know and buy enduring, quality companies when they’re trading cheaply. While you’ll have to perform some analysis to determine when a company is truly undervalued, it’s a worthwhile effort.
Just because a company’s share price has fallen, for example, doesn’t necessarily make it a good value. 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 the business does well, the stock eventually follows.”
Rather than chasing stock prices and thinking of them as disconnected entities, if you want to invest like Buffett, take the time to understand the business behind the stock.
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