How to Tell if a Stock is Cheap Or Expensive (The Warren Buffett Way)

Hey guys, and welcome back to the channel! In this video, we are going to discuss how you can tell whether a stock is cheap or expensive. There are a lot of different ideas out there, from valuation multiples to technical indicators to cash flow analyses. In this video, I'm going to break down why there's only really one way to truly understand the value of a business.

Yes, we'll run through that method and then finish off the video by listening to Warren Buffett himself explain this valuation approach. So, lots to cover in this one, so let's get stuck straight into it.

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This video is sponsored by Steak. Download the Steak app today and use the referral code AWC to get a free stock when you fund your account! Details in the description.

So, how do we tell whether a stock is cheap or expensive? Well, I was always taught to look for a stock that has a low P/E ratio, you know, one that's in the single digits. Hmm. Well, while the share price divided by the earnings can give us a quick and dirty comparison of what people are paying versus what the business is actually earning, it actually tells us more about the investor sentiment than the underlying business value.

You know, if it's got a high price but low earnings, that just means that investors buying the stock right now expect a lot, whereas low price with high earnings all that means is that investors buying the stock think that the stock or the business is a sinking ship.

Okay, but what about my technical indicators? You know, the stochastics just crossed up through the 20 line; the MACD crossed up through the x-axis. I know the big money is flowing back into this stock, which is going to drag that stock price up. Well, that may be true, but when you think about technical indicators, what's stopping the business from making a market announcement tomorrow that isn't taken well by investors?

You could buy the stock based on these indicators; all looks good, and then the stock would fall by 30 percent the very next day. Then what? So, as you can see, these methods of stock valuation all have pretty major flaws.

Unfortunately, regardless of how expensive Sir Basil Cunningham's trading course is, there's no quick way to accurately tell whether a stock is cheap or expensive. So how do investors do it?

Well, the first step is to ensure that there are no red flags—nothing that has the potential to drag the company to zero in a hurry. If the company has red flags, then literally no valuation can be trusted because the red flags could wipe it out, you know, simple as that.

So, red flags include a company that has no competitive advantage, and that usually shows up in the financials as an inability to show consistent growth. Another red flag is excessive debt. For example, a company might be growing and looking cheap, but if they're up to their neck in debt, then it may not matter how good the business is; growing a slight downturn could be the end of it.

Another red flag would be that the business doesn't currently make any money. I mean, how are we going to be able to accurately estimate how much we want to pay for something if that something doesn't give you anything back in return?

So, the first step is to watch out for the red flags because they can make the cheapest-looking business an instant deal breaker. But say you've got no red flags; then how do you determine whether a stock is cheap or expensive?

Well, it's by doing what's called a discounted cash flow analysis. Think about it like this: as an investor, when we're buying a stock, we're buying a piece of a functioning business. That business operates to produce a certain amount of cash each year.

So, it's a money-making machine—that's the way to think about it. Now think about this: if you had the opportunity to buy a money printing machine, how much would you pay for it? Exactly! It depends on how much money the machine can print for you.

You know, I'll pay a lot more for a machine that can print a million dollars per year than a machine that can print a thousand dollars per year. So that's what we do with our discounted cash flow analysis: we look at how much cash the business makes for its owners in a year.

That's called the owner's earnings; it's the operating cash flow minus the maintenance capital expenditure. Then another thing to know with companies is that most of them grow over time. So, we, through our understanding of the business, have to figure out how much the owner's earnings will grow each year.

This, unfortunately, isn't a quick and easy trick. Quite simply, the more you know about a company and the more you know about the industry, the more informed you'll be and the better your growth estimate will be.

Although the place I'd start is seeing how well the company has been able to grow their owner's earnings over the past five to ten years and then compare that number to similar businesses. Then what we do is we grow the current owner's earnings by our decided growth rate for the next 10 years.

After we've done that, we imagine we're going to sell the business for, say, 10 or 15 times the owner's earnings, and that number very much depends on the type of business you're looking at—whether it's a big energy company or something like a high-flying, high-margin SaaS company.

So overall, we've grown the future cash flows, figured out our one-time cash flow after 10 years from the sale of the business. Then we discount the future cash flows back to what they're worth to us today.

So we can't pay full price for those future cash flows, right? Because it's going to take 5 or 8 or 10 years before we actually get our hands on them. So we discount the future cash flows by our desired annual rate of return—say, 15%.

Then what we'd be willing to pay for the money printing machine right now is the sum of all of the discounted future cash flows. In my experience, that is the best way to accurately value a business.

Remember, as an investor, you're buying a piece of a money printing machine—that's all a business is. They do it all in different ways; some do it better than others, but they're all trying to print money.

So, if you're in the mindset that you're trying to buy a money printing machine, then everything else just follows logically. How much do I pay for the money printing machine? Well, it depends on how much money it makes.

Maybe it can make a hundred dollars next year and grow that money printing ability by twenty percent each year. Then I'll be able to sell this machine to someone else in 10 years for, say, 10 times the money printing ability at that time.

All right, now I want to achieve 15% returns per year. So, I discount those future cash flows by 15% annually. Then, if I add the discounted cash flows together, that will be what I would pay, what I could pay for the money printer.

Now, for a 15% annual investment return, in this case, that number happens to be $1,170. Now, the only last thing to remember is that, like all valuation methods, this one as well has flaws.

The flaw of the discounted cash flow analysis is that we're guessing future performance, and we might be wrong. So, the final step in all this process that we can't forget about is to take a buffer, take a margin of safety—twenty percent, thirty percent, fifty percent—depending on what you're comfortable with to ensure we cover the scenario that we're slightly out, we're slightly wrong.

So, for the example above, we might say, I'll pay $1,500 for the money printing machine. That would be a 30% margin of safety.

So, no, it's not about the P/E ratio; it's not about checking two charts and then buying a stock. Remember, at the end of the day, you're not buying a stock; you're buying a business. What determines whether a stock is cheap or expensive is the price of the business compared to its predicted future cash flows.

And now that you know these steps, I wanted to finish this video by playing a little clip from Warren Buffett himself, explaining exactly this approach. See if you can now follow along with what he's saying to these students.

“Well, intrinsic value is what is the number that if you were all knowing about the future and could predict all the cash that the business would give you between now and judgment day discounted at the proper discount rate, that number is what the intrinsic value of businesses. In other words, the only reason for making investment and laying out money now is to get more money later on, right? That's what investing is all about."

"Now, when you look at the stock, when you look at a bond, so means the United States government, it's very easy to tell what you're going to get back. It says it right on the bond; it says when you get the interest payments, says when you get the principal. So, it's very easy to figure out the value of a bond. It can change tomorrow if interest rates change, but you are—the cash flows are printed on the bond. The cash flows aren't printed on a stock certificate.

That's the job of the analyst is to print out, change that stock certificate, which represents an interest in the business, and change that into a bond and say this is what I think it's going to pay out in the future. When we buy, you know, some new machine for Shaw to make carpet, that's what we're thinking about, obviously, and you all learn that in business school. But it's the same thing for a big business. If you buy Coca-Cola today, the company is selling for about $110 to $115 billion in the market.

The question is, if you had $110 or $115 billion, you wouldn't be listening to me, but I'd be listening to you instantly. But the question is, would you lay it out today to get what the Coca-Cola company is going to deliver to you over the next two or three hundred years? The discount rate doesn't make much difference after, as you get further out. But, and that is the question: how much cash they're going to give you. This isn't a question of, you know, isn't the question about how many analysts are going to recommend it or what the volume in the stock is or what the chart looks like or anything.

It's a question of how much cash it's going to give you. That's your only reason. It's true if you're buying a farm; it's true if you're buying an apartment house, any financial asset, oil in the ground—you're laying out cash now to get more cash back later on. And the question is how much you're going to get, when are you going to get it, and how sure are you?

And when I calculate the intrinsic value of a business, when we buy businesses, and whether we're buying all of a business or a little piece of a business, I always think we're buying the whole business. Because that's my approach to it. I look at it and say, what will come out of this business, and when?

But the real question is Berkshire selling for, we'll say, $105 or so billion now. What can we distribute from that? If you're going to buy the whole company for $105 billion now, can we distribute enough cash to you soon enough to make it sensible at present interest rates to lay out that cash now? And that's what it gets down to.

And if you can't answer that question, you can't buy the stock. You know, you can gamble in the stock if you want to or your neighbors can buy it, but if you don't answer that question, and I can't answer that for internet companies, for example, there's a lot of companies, all kinds of companies, I can't answer for, but I just stay away from those."

All right, that will do us for today's video, team. I hope this video helped maybe, you know, if you're someone who's fairly new to stock market investing. Unfortunately, at the moment, there's a lot of crap going around that's just like, you know, check these three things and your stock is a buy; it will return 20% in one week. Unfortunately, you know, I wish it was that easy, but unfortunately, it's not. However, it's not impossible to fairly accurately value a business if you put in the work.

So overall, guys, I hope you enjoyed this video. Hope that gave you some insight. Leave a like on the video if you did enjoy it or if you found it useful. Subscribe to the channel if you haven't done so already.

And if you'd like a run-through of a full run-through in-depth explanation of this valuation method and also to others, then check out Introduction to Stock Analysis. That is a course that I made that I host over on my business, which is Profitable. Links are down in the description below if you would like to check that out. And if you want to check it out, you're also financially supporting the channel as well, so I really appreciate that.

But apart from that, guys, that'll do us for today. Thank you all very much for watching, and I'll see you guys in the next video.

Hey guys, thanks very much for watching the video! So every now and again, people reach out to me and ask what stock broker I use for the trading or the investing that I do over in the United States.

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So, Stake is the one that I use; I really do like their platform. And, of course, the reason that I like partnering with them is they give you guys a really good deal. So if you sign up to Stake using the referral code AWC—that's going back to Aussie Wealth Creation days, if you remember—if you sign up using the code AWC and fund your account, you're going to be given one free stock!

So, hey, pretty good bonus! It's better than a poke in the eye! So if you'd like to check that out, check out the links down in the description. Thanks to Stake, as always, for helping make this channel financially viable for me and sponsoring this content.

And thanks to you guys for watching! I'll see you guys in the next video.

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