We Study Billionaires - The Investor’s Podcast Network - TIP 002 : Warren Buffett Investing Basics part 2 (Investing Podcast)

Starting point is 00:00:00 This is episode two of the Investors Podcast. Broadcasting from Bel Air, Maryland. This is the Investors Podcast. They'll read the books and summarize the lessons. They'll test the waters and tell you when it's cold. They'll give you actionable investing strategies. Your host, Preston Pish and Stig Broderson. Hey, how's everybody doing?

Starting point is 00:00:28 This is Preston Pish, and I'm your host for the Investors Podcast. and I'm accompanied by my co-host, Stig Broderson. Hey, guys, this is Stig Broderson. Can't wait to spend my day with you. All right. So for today's episode, we've got two segments for the show. And for anybody who's joining us from the previous show, welcome back. We're excited to have you.

Starting point is 00:00:49 But if you're joining us for the first time and you're starting out with the second episode, we highly recommend that you go back and listen to the first episode because there was some important information that you need to know in order to kind of continue on into this episode. So in this show, we've got two segments. The first segment, we're going to continue this discussion that we had pertaining to the profit of the business. Profit is also another term for net income or earnings.

Starting point is 00:01:14 And what we're going to talk about in this episode is how do you get those earnings into your pocket? It's real nice to be able to say that those earnings are yours and everything, but it really doesn't make sense until people understand how does that money get into my pocket. So that's what we're going to be talking about in the first segment. And then in the second segment, we're going to be talking about a character called Mr. Market, which was a fictitious character that Benjamin Graham, who was Warren Buffett's professor at Columbia, that was a character that Benjamin Graham had come up with for his classroom at Columbia.

Starting point is 00:01:43 So we'll be discussing that in our second segment. So let's go ahead and just move into this first segment and let's talk about how a shareholder receives their earnings. So this is really quite simple. A shareholder receives the earnings of the business through two different paths. So when we talk about the earnings of a company, let's say that we're looking at one share of a business. And in our previous example from the last episode, we said that we had a coffee shop and then that coffee shop was broken up into 10,000 shares, which meant that one share was potentially worth $10. So if we're dealing with a $10 share, okay, that you'd buy on the market for $10, typically the profit that would be associated with that one share would be about $1. Okay, 10%.

Starting point is 00:02:29 And if a company is able to turn a 10% profit compared to its purchase price, that's a pretty good price to pay for owning a business. So how would you get, now here's the question that we're trying to solve here in this first segment. How would you get that $1 of earnings into your pocket as a shareholder? And how that happens is there's two paths. You can get paid a dividend, which you would receive cash, or the company could retain that earnings inside of the business itself, which would create more value later on because they could buy assets and a bunch of other things. Okay, so we're going to talk about those two paths in a little bit more depth. So remember, one dollar of profit,

Starting point is 00:03:11 $1 of earnings that are associated with owning that $10 stock. That $1, the first path is through the dividend. Okay, so let's say that this company paid a 30 cent dividend for the year. What would happen is you would have a brokerage account where you own that one share. And then that 30 cents would be paid straight into that brokerage account as just a 30 cent payment. You'd see 30 cents show up for that one share. So if you own 10 shares, you own 100 shares, you just take whatever number of shares you own. You multiply it by that dividend that you received, that 30 cents, and that's how much money you'd see show up in your account. So very often when you hear that the stock is paying like 30 cents dividend, you need to be aware whether or not they're talking about the dividend for a whole year or only for a quarter.

Starting point is 00:03:59 In the U.S., it is so that dividend is typically paid four times a year. In Europe, it's very often that's only one time a year. So you need to be very specific about that when you hear that. So that's a great point that Stig brings up. So let's say we received a 30 cent dividend. That's for the entire year. So if you're looking at receiving that 30 cent dividend, you would receive that 30 cent dividend, you would receive that across four quarters of the year.

Starting point is 00:04:25 So the first quarter you might receive 7.5 cents. The next quarter you'd receive another 7.5 cents. And then in totality, that would add up to 30 cents for the year. It doesn't sound like a lot of money, but you've got to realize you're only dealing with a share that might cost $10. So you've got to think proportionally here and how all this works. So the next question you might be wondering is, okay, so I got 30 cents of the dollar.

Starting point is 00:04:51 profit that I earned as a shareholder. So where did that other 70 cents go? And do I get that or, you know, what happened to it? And the answer is that that 70 cents is retained by the company, okay, and it sits there in the company accounts, either as a tangible item, as cash. It could be really a whole host of different things, depending on how the management wants to employ that retained earnings. But for you, in the most simplest way that I can describe this, is that 70 cents is retained as your earnings. And as time marches on from this year to the next year and the year after that, if the company continues to retain these earnings, that's going to continue to give management more ability to purchase more assets, to pay off liabilities. And so that share price should reflect that growth. So Stig, I saw you had something you wanted to add.

Starting point is 00:05:47 Yeah, so as for you as a stock investor, you need to see this as a very simple trade-off. If you're looking at a high dividend, I mean, that's fine because then you will receive a lot of money in the short run. But in the long run, there would be less cash retained in the company that the company can grow from. So there's really hard to say, do we want a high dividend? Well, you might want to have that. But then you are really paying in the long run with a perhaps slower growth. Let's take a quick break and hear from today's sponsors. All right.

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Starting point is 00:10:41 So let me just talk through two different scenarios. So I'm a little bit younger. I'm in my 30s. So I prefer to have no dividend, okay, because that's tax that I have to pay on receiving that dividend. And also the company is taxed before that dividend goes out the door. So when you look at it from an ownership standpoint, I'm kind of being taxed twice by receiving a dividend. The company's tax, so whatever that tax is, that's being taken out of my retained earnings that's being left over. And then whenever I receive it as a shareholder, I am being taxed on that money. So that's something that's very important to understand.

Starting point is 00:11:19 And so if I'm allowing the company to retain the earnings, or I'm basically buying a company that retains earnings, that money has an ability to compound and not get taxed and go through that friction of tax as much as receiving a dividend. Okay, so that's my opinion as a younger investor. Now, if you say you're in your 60s or 70s and you're retired at this point and you're relying on those dividends to come in to supplement your lifestyle in the way that you're living, you probably would have a different opinion because you're using those dividends for a completely different purpose. In one case, the person's using it to grow their net worth. The other person is using it to sustain their lifestyle.

Starting point is 00:12:01 So it really kind of depends on who you are, what you really plan on using these earnings for, depending on how you want to pick the company. Now, the other variable to this, so that's the first variable is who are you and how do you plan on using the money that this company's making for you. The other variable to this is,

Starting point is 00:12:19 do I trust the management to make good decisions with the retained earnings? Okay, so that's really kind of the other piece of it. So whenever you look at a company like Berkshire Hathaway, they don't pay any dividends. You have a person like Warren Buffett running the company and his average return is 20% a year. That's somebody that you can trust with retained earnings and know that he's making very good decisions with the money that he keeps within the company. And so when you go back and you look at the stock price of Berkshire Hathaway, you continue to see Berkshire Hathaway grow at a crazy rate with their share price because that's being reflected by the retained earnings and what he's doing with that money that he keeps.

Starting point is 00:12:58 If you go to a different company, you might not see the same results. So then you might prefer a dividend over the company retaining those earnings. So, you had something you wanted to add. So, Preston, what you're really saying is there are no rule of thumb. You aren't going to say I need at least a 20% payout ratio or a 30% payout ratio. That's not how you look at dividends. That's exactly right. So, you know, everyone's looking for that rule of thumb.

Starting point is 00:13:25 That it's kind of hard sometimes. So with this particular area of interest where you're talking about, should I receive a dividend, not receive a dividend, it's really kind of dependent on those two variables. The first being, who are you and kind of where are you at in your life and what are you using the money for? And then the second variable being, you know, do you trust the management? Is the management made good decisions in the past and do you expect them to make good decisions in the future as to how much of a dividend you want to receive if one at all? So my personal recommendation, if you are a new shareholder, you might want to pick a company where there is some sort of dividend. And the reason for that is really that if the company is paying out a dividend, it means that they're making decent cash and they actually have excess cash.

Starting point is 00:14:14 And that is very nice if you're not completely certain about the company that you're looking at. And I have to agree with Stig for first time investors because it's really good to kind of see that materialize into your account. To be able to see what your company is doing for you, these shares that you're buying. It's not like it's some methodical thing that doesn't really exist. You're actually seeing the company make a profit and then you're actually seeing some of those profits show up into your bank account. I think that's a really good thing for first-time investors. So something else that I want to talk about real quickly. So it's a bad thing when you're receiving

Starting point is 00:14:51 a dividend and that dividend exceeds the profits or the earnings that they're. company. So let's walk through this. So let's say that your earnings, the profit of the company was $1.00. Okay. And let's say that you were receiving a dividend of $1.20 for the year. I think everyone can kind of see there's a problem with that. It doesn't make any probable sense that a company could be paying you a dividend that's 20% higher than the profits that they made for the year. Okay. And believe it or not, that might sound like really obviously, like, oh yeah, I'm sure there's like no companies doing that. But to tell you the truth, there's a lot of companies that do that. And it's actually quite surprising when you start looking around the internet and kind of researching

Starting point is 00:15:32 different picks and you go down and you look at the earnings per share, which is, here's a term here. This is a very important term. EPS, okay, that's earnings per share. And when we said that there was one dollar of earnings for that one share that we own, that's exactly that number. So if you'd go on the internet and you'd look up a company, call your, let's just say you're looking up at Chevron or Exxon Mobil or one of those kind of companies. And you go down and you look at the EPS, the earnings per share, that's the profit per share. Okay. So when you look up that number and it's much higher than a dollar, but let's just say that it's a dollar. Okay. And you see that, you know that that's the profit that the company

Starting point is 00:16:13 is made for an entire year. Okay. That EPS is profit for one year. So when you see that number and you compare it to the dividend, and let's say the dividend for whatever reason was $1.20, which it's not for those two companies that I just named. But you would look at that and say, how is that company paying me this much cash right into my brokerage account when they're only making $1 a year? And that's a question that is a very good one and one that should really make you shy away from that company. So that's kind of a discussion.

Starting point is 00:16:49 I'm sure we could go into a whole lot more. But in general, I think the thing that we got to take away from this first segment is twofold. Your profit, your earnings is paid out in two different directions. The first direction is it could be paid out as a dividend. Some companies don't pay any dividend. If that's the case, all the money is then retained by the company to purchase new assets, to pay off old debts. And when they do that, the equity of the business is going to grow, and you're going to see that reflected in the stock price of the business over time.

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Starting point is 00:21:00 So like I said in the intro, Mr. Market was a fictitious character that Benjamin Graham used for his students at Columbia. university whenever he was teaching them. And like I've said a couple other times, Benjamin Graham was Warren Buffett's professor that taught him all these different things that really kind of turned Buffett into the billionaire that he is today. So very important person to discuss when you talk about value investing. So Mr. Market was this fictitious person that would show up at your doorstep. So imagine a salesperson with the suitcase and the, you know, the suit on and he would show up and he would knock on your door and when he would arrive, he would say, hey, I'm

Starting point is 00:21:40 selling all these different things and he'd open up the suitcase and show you what's inside. And the way Graham described it was that the stuff inside the suitcase were just a bunch of different stock picks. And Mr. Market would come back every single day and he'd show up, maybe call it 9 o'clock in the morning. He would knock on the door every single day at 9 o'clock and he'd open up his briefcase and you'd say, hey, I'm selling these things. And these are the prices of these things today.

Starting point is 00:22:06 And the reason Graham liked this example is because he showed students that Mr. Market is your servant and not your guide. Okay. And what he meant by that is this person showing up at your door and offering you these prices. He is there to serve you. You are not to look at what he's selling and say, oh, well, that price is this today. So now I need to be scared or I need to be excited. Instead, you need to look at what he's bringing you and saying, you know what, I think that that stock right there, stock A, is worth $10.

Starting point is 00:22:41 And Mr. Market showed up today, and he's selling it for $15. Okay. Well, that's a lot higher than what I'm willing to pay. So I'm just going to tell Mr. Market to go away. Okay? And so then Mr. Market would leave. And then let's skip one day in advance. And Mr. Market comes back and he knocks on your door.

Starting point is 00:22:57 And you open up the door, he comes in and he opens up the briefcase. And stock A, today, he wants to be. to sell it for $8, okay, which is completely different than the previous day. And so what Graham is teaching his students with this example is look at what the market is offering you. Okay, don't look at the market as saying, oh my God, I should be scared because the price he offered the day before was 15 and now he's offering me eight and that would scare, and they're looking at it relatively instead of looking at it, what do I think share A is worth and what, is Mr. Market offering me as a servant. Okay. So that's the, that's really what he's trying to drive

Starting point is 00:23:39 home here with this Mr. Market example. So Stig, go ahead. I see you had something you wanted to add. Yeah, guys. So Preston's really saying that patience is very, very important for you as a stock investor. I think we can do a whole new podcast about what kind of mental skills you need to have to be a stock investor. But the great thing to understand about Mr. Market is really that he comes by your office every day. every Monday to Friday he drops by your office and he will give you new quotes every day and even on a daily, hourly base. So patience is really, really important. You don't have to buy stocks today, not next week or perhaps not this year. I know that Warren Buffett used to say that if he gets one good idea each year, that is enough to make him wealthy. So, you know, and we could go back to the coffee shop example that we had from the first.

Starting point is 00:24:31 episode, you know, if you were trying to buy a coffee shop in your local town because you thought it was an outstanding business and you approached the owner and you said, hey, I'd like to buy your coffee shop and the owner says, well, I want to sell it for $300,000. And, you know, you maybe thought it was worth $100,000. You're not going to get all emotional and say, oh, my God, they want so much higher. You're just going to kind of take it as is at face value and say, you know what, that's a little higher than I was willing to pay and just kind of walk away from the offer. That doesn't mean that maybe six months later you go back to the same person and say,

Starting point is 00:25:05 hey, I'm still interested in buying your coffee shop. Would you be willing to sell it to me for $100,000? And then the person says, yeah, you know, I haven't had any luck. I'll sell it to you for $150,000. Okay. So now it's a different offer on the table. And maybe you might say, yeah, that's a little higher and I wanted to pay, but I do want to own it, so I'm going to buy it at $150, okay?

Starting point is 00:25:26 Same exact thing on the stock market, okay? the same exact thing. And when people start looking at it from that vantage point of, hey, this market's just offering me a different price. That doesn't mean that the price is right or wrong. You're the person that's got to determine that. And that's really kind of the whole gist of what Benjamin Graham is trying to get at with this Mr. Market example. So, Stig, you had something you wanted to add. Yeah. And what's really great about Mr. Market is that he does not get offended. So for instance, if I walk down to my local coffee shop and I asked him every day so sir cannot buy your business, he would probably get pretty annoyed with me.

Starting point is 00:26:06 But Mr. Margaret is a much more pleasant guy. He would drop by office again every day with a new price. And that's actually a huge advantage. You don't need to spend so much time, so much energy because you get the prices every day. Okay. So I think that that kind of concludes this second episode. the points that we really want to drive home in the first segment is that when you're paid this profit, there's two ways that you can get it through a dividend or retained earnings.

Starting point is 00:26:33 And then in the second segment, we were talking about Mr. Market and how you just need to be a patient investor and wait for the price that you know the company is worth and then buy it whenever it's around that price point. Okay, so that concludes our show. And if you guys are enjoying this and really like it, we would really appreciate your support on iTunes. Remember, if you go to ask theinvestors.com and you ask a question there, you can record your question and we'll play it on the air. We'll send you a free signed copy of the Warren Buffett Accounting Book. And we just really, in general, just appreciate your support. So we look forward to seeing you in the next episode.

Starting point is 00:27:11 And thanks for joining us. Thanks for listening to The Investors Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www. Submit your questions or request a guest appearance to the investors podcast by going to www. www. Asktheinvestters.com. If your question is answered during the show, you will receive a free autographed copy

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We Study Billionaires - The Investor’s Podcast Network - TIP 002 : Warren Buffett Investing Basics part 2 (Investing Podcast)

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