Buy low, sell high: How Buffet does it

BUY low, sell high.

This is the most popular theory in stock market investing. But the question is -– how would you know when a stock's price is ‘low’?

The key: Compare a stock's price with its ‘value’.

How is price different from value?
-- Price is what the market is willing to pay for the share at a given time. It fluctuates from minute to minute.

-- Value of a stock is the worth of its underlying business. It is more stable as fortunes of a company do not change overnight.

Buy when price is lower than value
If a share's value is Rs 150 and price is Rs 125, then you get the stock at a discount of Rs 25.

While there is no guarantee that the price will not go below Rs 125, the probability is low.

This principle is called the 'margin of safety' and finds it roots in the teachings of legendary investors -- Warren Buffet and Benjamin Graham.


How to find out a share's value?

To begin with, you can read financial statements and understand the nitty-gritties of stocks.

If you are willing to walk that extra mile, then pay heed to these valuation methods that Warren Buffet swears by:

Method 1:
Look at the net liquid assets per share.

Net liquid assets per share = Current assets (cash, debtors, liquid investments etc) - liabilities
Number of shares


Thumb rule: Warren Buffet prefers paying not more than two-thirds of such value for a stock.


Method 2:
Look at the PE (Price to earnings) growth ratio.

PE growth ratio = Market price/ Earnings per share
Annual EPS growth

where Annual EPS growth = Current year's EPS – previous year's EPS x 100
Previous year's EPS'


Thumb rule: A PE growth ratio of 1 indicates a fairly valued share; less than 1 means undervalued; and more than 1 means overvalued.

PE: an indicator of margin of safety

Let's assume you buy a share at Rs 550 whose EPS is Rs 50. In one year, you earn Rs 50 on an investment of Rs 550, that is, a return of about 9 per cent.

You can earn 8-9 per cent risk-free returns on bank deposits as well. So, the margin of safety in this case is practically nil.

To reduce the risk, we must have a higher gap.

Thumb rule: Warren Buffett recommends this gap to be at least 1.25-1.5 per cent.

Last word: During a bull run, investors pay a high price for any and every share. So, it becomes difficult to find stocks with a high margin of safety.

It is in bear markets, as the one we are in now, that there are opportunities to spot the gems.