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PART II
Advanced Buffettology
You have just finished the qualitative portion of the book. What lies ahead is the quantitative portion. It is the math segment. It contains the equations that you will need to
master to determine if a stock's market price makes business sense. This part of the book is essential to your reaching a full understanding of Buffettology. You have to have
these skills to profitably implement a business perspective investment program. We have worked hard to make the equations very accessible. If you have the financial
calculator we recommended earlier, the math becomes a breeze.
Now the key to this part of the book is the mathematical tools section, which includes, first, a number of small chapters instructing you in the use of mathematical tests that
help determine at what price a potential investment makes business sense. This is introduced by a chapter on the analyst's role in ascertaining earning power. Following this is
a chapter of case studies, which show you how to apply what you have learned, and then a chapter entitled "How Warren Got Started: The Investment Vehicle," which is
about how to start your own investment partnership, just like Warren. And last, but not least, we close with a chapter that contains fifty-four companies to look at, which is a
list of companies in which Warren has invested in the past and that your authors believe are still part of his investment universe, and a chapter entitled "Waiting for the Perfect
Pitch."
Are you ready? Let's begin.
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The Analyst's Role in Ascertaining Earning Power
Warren uses a series of mathematical valuation techniques to ascertain the earning power of a business in which he is interested. By ascertaining the earning potenial of the
business, he can then estimate the annual compounding rate of return that he expects the investment to earn. Warren, just as Graham did, has found that it is possible to predict
the earnings and dividends a number of years ahead for some businesses.
Wall Street, though the home of many a financial analyst, has never been fond of making long-term projections for business. They argue that it is hard enough to estimate the
current or coming year's earnings with any accuracy. As a rule, Wall Street analysts prefer to calculate future earnings of a company for only a relatively short period of time,
usually twelve months or less. This is the end of the quantitative inquiry.
Graham stated in Security Analysis that the rest of the Wall Street analyst's study is qualitative in nature and "leads to an over-all opinion, stated primarily in descriptive terms,
about the standing and prospects of the enterprise." Graham further stated,
The typical study of this kind will culminate in a buying recommendation, which is only rarely developed in a careful and thoroughgoing manner. In some cases the stock is
called "cheap" and "attractive" because it is selling at what seems a low price in relation to current earnings or those about to be realized. While such a measurement is
important, it is hardly adequate for an investment decision, since value cannot soundly be established on the basis of earnings over a short period of time.
Graham went on to say: "The analyst could do a more dependable or professional job of passing judgment on a common stock if he were able to determine some objective
value, independent of the market quotation, with which he could compare the current price."
In Graham's world next year's profits were of importance only if they could be viewed as indicative of the longer-term earning power of the business. The greatest chance for
the investor to profit was to formulate a long-term opinion on the earning prospects of the business in question.
This is where Warren has made the greatest inroads and advancements in the theory of security analysis. Warren has developed the selective criteria for the identification of
the businesses whose long-term earning power can be identified and projected. With this advancement, he has been able to see the long-term investment value of these
23-Oct-10