The Formula That Made Buffett a Billionaire
When 24-year-old Warren Buffett received a phone call offering him a job in New York City, he accepted without asking about the salary.
It was arguably the smartest – and most profitable – decision he ever made.
That’s because Buffett knew the man who had just employed him – a man he studied under at Columbia University – held the proverbial keys to the kingdom.
His name was Benjamin Graham.
Years earlier, Buffett had offered to work for Graham for free. But Buffett was kindly turned down.
Years later, he finally got his wish (and with pay).
Even so, Buffett’s life was about to change in ways even he could not foresee.
For Graham was about to teach him something far greater: how to translate his knowledge into an abundance of riches.
The Godfather of Investment Analysis
Graham was a phenomenal figure in the history of investing. But his importance stretches beyond his relationship with Buffett.
Graham founded the value investing school. But he also gave birth to the field of security analysis.
He established himself as a first-class investor during his years managing the Graham-Newman Corporation with his business partner, Jerome Newman.
The firm had an annualized return of 21%, compared with the market’s 12% rate of return.
But the firm’s great success was due to Graham’s insight, which was the foundation of the firm’s investment strategy.
It was summarized in the firm’s 1946 shareholder letter: “To purchase securities at prices less than their intrinsic value… with particular emphasis on purchase of securities at less than their liquidating value.”
But the struggle of analysts has always been to determine a company’s intrinsic value.
Calculating the intrinsic value of a company requires thorough analysis. But such analysis is not always easy in a fast-paced market.
Graham knew that it was helpful to have a “guesstimate”… a simple method for estimating a company’s value on the fly.
In his book Security Analysis, Graham laid out his original pen-and-paper formula.
Intrinsic Value = EPS x (8.5 + 2g)
EPS stands for earnings per share…
The average price-to-earnings for non-growth stocks at the time was 8.5…
And “g” represents the long-term growth outlook of the company.
Once you plug in the numbers, the formula hands you an intrinsic value estimate. Then, all you do is purchase stocks trading at discounts to their true values.
But despite the success this formula handed Graham and his followers…
Almost no one uses it today.
Investment analysis has become a more complicated and competitive field. Most successful value investors have developed their own approaches to measuring value.
In fact, Graham himself noted that his formula was not perfect. He made revisions to the formula over time, acknowledging its flaws.
Even so, the principles and strategies of Graham still live today. And the basic idea of buying stocks below their true values is as important as it’s ever been…
Especially in today’s market.
As Chief Investment Strategist Alexander Green reported previously, stocks are currently trading above their historic average price-to-earnings ratios.
“That doesn’t mean the market’s about to go down,” said Alex. “But what it does mean is that companies that are trading at a much more attractive discount… are certainly set to provide much better performance going forward.”
The fact is this is an ideal time to buy value stocks… and the market knows it.
The recent wave of capital pouring into value funds – especially during the first half of this year – compared with the flow into growth funds is proof positive of that.
But no matter what stage of the market cycle we’re in, it goes without saying that overpaying is a bad way to invest.
Know the value of what you buy, and pay at as great a discount as possible.