We Study Billionaires - The Investor’s Podcast Network - TIP 088 : The Intelligent Investor (Investment Podcast)

Starting point is 00:00:00 We studied billionaires in this episode 88 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 Sting Broderson. Hey, how's everybody doing?

Starting point is 00:00:30 out there, this is Preston Pish, and I'm your host for The Investors Podcast. And as usual, I'm accompanied by my co-host, Stig Broderson out in Denmark. Today, we've got a book that a lot of people have heard us talk about. The author of the book is Benjamin Graham. Benjamin Graham wrote two books that were really famous, first one security analysis, which we've done an episode on. And then the other book is The Intelligent Investor. So to just give everyone a quick background, if you're joining us for the first time on the show, and maybe you don't know who Benjamin Graham is, So Benjamin Graham was Warren Buffett's professor at Columbia. And Graham started teaching at Columbia University back in 1928.

Starting point is 00:01:08 He wrote this book and it was the textbook that he used in his class. And the textbook was called Security Analysis, which we've done in the previous episode. How many episodes ago was that stick like 20 or something like that? Yeah, that sounds about 20 episodes ago. And so Ben Graham wrote this book, Security Analysis. Security Analysis was published back in 1934. So all of this was really kind of going on during the Great Depression. And Graham then was professor for quite a few years.

Starting point is 00:01:35 He ended up being the professor for Warren Buffett. And Warren Buffett, whose net worth is, I don't know where it's at right now, maybe $70 billion, $65 billion, something like that. It's way up there. One of the wealthiest people in the entire planet has said that everything that he has learned and his investing approach was completely shaped by Benjamin Graham, the author of these two books. And so that's why we really like to place a lot of emphasis on Benjamin Graham. He's the founder of value investing.

Starting point is 00:02:05 A lot of people have attributed their massive net worth to following the principles of Benjamin Graham. So in today's episode, we're going to be reviewing the intelligent investor by Benjamin Graham. And where this book is a little bit different than security analysis is that the intelligent investor is kind of a watered down, maybe easier version, definitely. geared towards the common investor opposed to like a security analyst that does it professionally working for a big bank. So this is for the common investor and how they can invest. So what we're going to do, Stig and I came up with, actually Stig came up with the agenda, I should say. And he emailed it to me. But Stig came up with the agenda. And the way he broke it out is he said,

Starting point is 00:02:48 Preston, let's do chapters one through seven in the first segment. Let's do chapter eight, because that's a really important one. And we're going to do nine through. 19 and then chapter 20 all by itself. So we'll talk about intrinsic value, all sorts of things, and hopefully you guys enjoy this one. So let's go ahead and start this off. We're going to be reviewing the first seven chapters, one through seven, and kind of hitting the highlights between the two of us. So the book starts off with a very, very important discussion. And that discussion is distinguishing between an investor and a speculator. So here's the difference. Graham says that and when you're an investor, you're not seeking a massive return in a short duration or short period

Starting point is 00:03:33 of time. You're looking for a reasonable return. And so Graham doesn't necessarily say a reasonable return is 10% or less or anything like that. He leaves that really up to the reader to determine. But I think Graham would probably say if you're looking for a 50% return in a one-year span or a one-year time frame, that's probably getting into the realm where you're looking for excessive gains and that really starts to become speculative in nature. So the second part is that when you have an investor, he's doing something to promote the safety of the return on the principle. So an investor won't do anything that really compromises his principle in any type of extreme

Starting point is 00:04:13 manner. So, you know, let's say that you were going to invest in a large cap company. Let's just say it was a company like Apple. And you were looking at Apple's returns and their revenues were really steady. they had all these consistent numbers, and the expectation is that they're going to continue to earn at least the level that they're earning today into the future. And there's no really anything that you can see on the horizon that would cause a major disruption in that in the next couple of years.

Starting point is 00:04:41 That would be an example of investing because at this point in time, you can't necessarily say the revenues or the net income is all over the place, so it's not something that you can actually project or predict where the bad event is going to occur. That's where you get into more of an investing approach opposed to a speculative approach. You know, back in the day, Sears XM Radio, their net income was up and down. They were moving stuff off their balance sheet onto their income statement. It was just kind of a mess if you looked at their financials. And so at that point in time, you could, as an investor versus a speculator, you could look at that pick and say, you know, next quarter, they could have negative net income where they just had a pause. And

Starting point is 00:05:23 That could totally happen based off of their track record and the things that have happened. If you know that as a person, as a person that's looking to invest up front and you know it could potentially be bad, you've identified an event that could jeopardize your principle, which now goes into what Ben Graham would call speculation opposed to investing because you already know the event that could really kind of come crashing down. So that's it. Those are the two things. You've got to be able to protect your principal and you've got to go after things that are giving you reasonable returns.

Starting point is 00:05:58 And that's what he would classify as investing. So here's the direct quote out of the book. He says, investing is promoting the safety of the principal and an adequate return. So that's where I'm pulling that from. And this is big. I mean, this is huge for a person to really kind of understand that. I know it sounds really simple. but if you aren't doing that, then you are speculating.

Starting point is 00:06:22 Then you are saying, I feel like this is the direction things are going to go in. Anytime you start throwing out the feel word opposed to, I have looked at the company's cash flows. They have been very consistent over the last five years. Looking towards the future, I expect those cash flows to continue to remain consistent, if not slightly grow. And because of that, when I do a discount, cash flow analysis, taking those future cash flows and discounting them back to today's present

Starting point is 00:06:52 value. I expect the value of the company to be $35 a share at a 7% discount rate. If it doesn't sound like that, that's how, you know, when Stig and I are doing the intrinsic value of an individual company, that's the conversation that we're having in our head and that we're actually writing out in order to determine the value of something. And here's a really key point. In all of that conversation, we're saying the competitive advantage of the company will be sustained or the expectation of the competitive advantage will be sustained during that period of time. Those are the things we're saying as an investor. Now, on the show, because it's a lot more fun to talk about this kind of stuff, on the show,

Starting point is 00:07:32 a lot of the times we're talking macro and we're talking, you know, what we think from a speculative point of view, yeah, I think Japan's going to be, you know, a disaster. But we're really kind of stepping into the realm of more speculation when we talk about that kind of stuff on the show, then really how we invest our money. Yeah, so the way to think about investing is that it's really, really boring. I think you might even have Chalemonger have a quote or something like that. He's been really been making his money just by waiting. I mean, and who think is fun just to wait? And if you're looking for action, if you're looking for a lot of things to happen really fast, investing is probably not for you. As an investor, there is no action

Starting point is 00:08:14 at all. You would buy a company and you will hold it for 10, 20 years, perhaps the rest of your life. So really think of investing at something that's really boring. That was actually my key point here. One extremely important point from Chapter 1 to Chapter 7 is Graham's discussion about active and passive investing. I think his definition of a passive investor is really interesting in today's context because for the passive investor, he's really talking about finding high quality picks and then just holding onto them. I think if Benjamin Graham was lied today, he would probably say something like find an ETF that has a tweak of value in it. That's how I would assume Benjamin Graham would look at the passive investors today. The really interesting thing about

Starting point is 00:08:59 passive investing is that when reading the intelligent investors, the guidelines he provides for really solid picks, I think they're just timeless. When I read that today, I'm thinking, that sounds like a great idea. That's probably what once you do, if you had no opinion about the market, if you have no opinion about the sustainable competitive advantage, fine blue chip stocks with these given criteria in terms of dividend payments, conservative financing, and so on. You'll probably do better than most active investors. And what Stig's really hitting at in the book between passive and active, Graham describes in the book as the defensive investor and the aggressive investor. And so here's a quote from the book that Graham has for the aggressive investor. He says, the aggressive investor

Starting point is 00:09:45 will expect a fare better than his passive equivalent, but his results may well be worse. And he gets into a lot of discussion about that, where he says that these aggressive investors, they're armed with all this information, and they're actively trading. They're using the speculative approach, if you will, and they're actively trading and making all these decisions. And he says, But so is everybody else that's armed with that same amount of information. And what he finds is these guys are going after and trying to get a 12 or 15% return or the higher end of this return. But what they actually get is a return is lower than the defensive investor who's really just kind of going after maybe call it a 7% return, maybe a little lower in today's markets than when Graham wrote this.

Starting point is 00:10:30 Because back then you were at different interest rates and different multiples and stuff. But now I think if you're going for 7% these days, you might be stepping into something really risky. I call this the active investor. Actually, if you read the book, he would sometimes call it the enterprising investor or the aggressive investor. Like, I remember the first time I read this book, I was like, how many types of investing are there? And it seems like there's only two. He just uses a bunch of different terms. Before we want to say one quick thing.

Starting point is 00:10:59 I really respect Benjamin Graham as one of the biggest thinkers in terms of investing. as a writer, I'm not really sure that was his forte. He was bad. No, I'm glad you brought this up because people need to be prepared because if you're listening to this and you go out and you buy his book, it's not an easy read. It's quite dry. It's difficult if there's financial terminology that you're not familiar with.

Starting point is 00:11:22 You will probably really struggle with this book. Even though it's the dumbed down version of security analysis, I remember the first time I read this because I didn't have a background in financial accounting and things like that, man, did I struggle with this book? I mean, it was brutal. I just knew it was a really important because Warren Buffett and all these other guys had said it was so important. But man, when I first picked it up and started trying to read it, I struggled. It was very difficult. Yeah, and it's funny because in financial accounting, as many our audience know, we have a lot of different terms for the same things. And obviously, Graham, even though he's a professor and he's used

Starting point is 00:11:57 to teaching people, he would just use all the almost like the more different terms for exactly the same thing, the better. So it's definitely not your average textbook. But just one quick thing I would like to say about the active investor is that he would be saying you should buy on popular stocks. And the way that Benjamin Graham looks at this is that he's showing people at table of PE ratios. And he's actually saying, and this is, I think the reading the book is written in 1949. And already back then, he was conducting studies in terms of how will companies perform if there is in this style in terms of. of PE. And I think he was just so much ahead of his time because he didn't have a computer

Starting point is 00:12:37 or anything like that at his disposal. He just thought this would make sense. And then he conducted a lot of research and found, okay, as you probably buy, unpopular stocks measured on a PE ratio basis. I think that was really interesting. And the last thing I want to say about the active investor, and this is something we return to later in the podcast, is that he is always comparing price and quality. He's saying, as an active investor, well, you might buy high quality companies, but you might also buy low quality. It depends on the price. So I just think that's really the discussion Preston was referring to previously when he was talking about discount rate and the earnings. Like, all that is good as fine. But we have to speak about what is the valuation.

Starting point is 00:13:23 And that's why we have this conversations between the two of us. And we're going to talk a little bit more about intrinsic value later in the episode. And we have a tool for calculating that stuff. We'll hand you guys off to. So if you're wanting that, just stay tuned. We're going to get to it here later on. So the next thing we'll talk about in this group of chapters that we're discussing right now, which is 1 through 7, is inflation and corporate earnings. So Graham's opinion was that stocks or companies were somewhat inflation proof, not 100% inflation proof. So don't think that if you buy a stock that it's going to be protected completely by inflation, but he said that a portion of it is protected. Now, he doesn't really kind of get into how you would saw or figure out

Starting point is 00:14:08 like a mathematical number of how much of it is or is not. But he's saying if you're comparing it to a bond, a bond is 100% impacted by inflation. So, and Jim Rickards talked about that a little bit in our interview where he was saying, you know, if the inflation rate is 5% and your interest on your bond is 3%, well, the person who owns the bond is getting tore up. They're just getting crushed because the inflation rate is exceeding the money that they're actually getting back. So with a stock, Graham doesn't say how much, but you're partially protected from that inflation piece. Now, it's really interesting. I can't remember the year that Warren Buffett wrote a shareholder letter discussing this exact topic. But Buffett talks about why that exists, why companies are somewhat

Starting point is 00:14:55 inflation protected. And where Buffett gets into it is a company that has a lot of intangible assets on their balance sheet, they're actually protected more from inflation than a company that has a lot of tangible assets on their balance sheet. And his reasoning is when the company has to replenish their inventory or they have to replenish their property or whatever that tangible asset is on their balance sheet. When they have to replace that, they have to pay the higher price of the inflated price of whatever it is that they're replenishing it with. And so that portion of the company's revenues that then support the balance sheet, sustainment, and things like that, that's what's impacted by inflation, whereas if, let's just say you had an intangible asset like a brand or

Starting point is 00:15:39 maybe digital media that you're selling on the internet or something like that, the price can just be simply adjusted to the inflated price. And you're not really having to deal with inventory or anything like that where you're having to pay a higher price. So that's where Buffett kind of went and took Graham's idea and took it to a whole new level. Now, here he is, taking his professor's content and just elaborating on it more. And just kind of you can see how he just blossom from some of this information that he learned as a young kid and just ran with it as an adult later on in his life. If you ever heard Warren Buffett talk about the intelligent investor, he would say, you need to read chapter 8. and you need to read chapter 20.

Starting point is 00:16:20 So that's also why we decided to have these four segments. And one of them is chapter 8 which is Mr. Magget. So let me just try to describe the way that Benjamin Graham might have described this in his class. So the way he liked to describe it is he'd say, imagine that you're at your house and you're just kind of sitting there reading the newspaper on your chair and the doorbell rings. And so you go over and you open up the door. And there's a gentleman there. he's dressed up in a suit and his name is Mr. Market.

Starting point is 00:16:49 And so Mr. Market comes to your door literally every single day, kind of the same time. He rings the doorbell and he says, hey, I've got these companies that I want to sell you. And he says, I've got this one here. It's called XYZ and I'm selling it for $30 today. Yesterday it was $35, but today I want to sell it for 30. And then he says, I have company, you know, ABC. Yesterday I was selling it for 90, but today I want $100 for this one. And so the way he was describing it is each day, this guy is going to come back with a different price.

Starting point is 00:17:23 Sometimes he's going to want more. Sometimes he's going to want less. Sometimes he's going to want way less. And you as the calm, competent, consistent, balanced thinker that you are need to listen to what he's offering you and then make your own conscious decision on what something is worth. So whenever he comes and says company XYZ and he wants to sell it to you today for $30, that's his offer. Now, what do you think it's worth? If you think it's worth $50, well, and he's offering it to you for $30, well, that's a heck of a deal. And you should maybe buy some of that from him because he's offering you at a great price.

Starting point is 00:18:05 Now, the other company, ABC, if he wants $100 and you think it's worth $75, why in the world would you buy that if he's offering it to you for $100? It makes no sense. And so this is kind of the example that he would use in his classroom to teach students that it's a choice. The price that you're being offered on the market is a choice for you to determine whether you think that that's a good price or a bad price using your own analysis of what you think something is worth or the value or the intrinsic value, which Stig is talking about. The price is just that. It's an offer. It's somebody saying, hey, I'm going to sell you my car for $35,000, even though you could go to a lot right next to it and buy it for $25. It's an offer.

Starting point is 00:18:51 You don't get upset. You don't get angry. You just kind of look at it for what it is. And be like, yeah, that's a bad offer. No, thanks. And that's why that chapter is so important, so incredibly important. In fact, Stig said, in the intro of the book that Warren Buffett provides, the preface, that is one of the – Warren Buffett made four points.

Starting point is 00:19:09 I'm going to just on to read these out loud to you real fast. Warren Buffett says investing doesn't require a high IQ. Warren Buffett says successful investing is a result of implementing a sound strategy and being able to control your emotions. This book, the intelligent investor, provides the strategy and you need to provide the emotional control. The next one is pay attention to chapter 8 and chapter 20, which we're just talking about chapter 8.

Starting point is 00:19:34 And then the last one, which is a really interesting point, he says, outstanding results depend on three factors, intellect, effort, research. and the number of market swings, you get the opportunity to experience. And notice how he says the opportunity to experience a market swing. So when you have a major downturner, Warren Buffett looks at that as an opportunity because he knows that price and value are completely out of whack, and that's his ability to really kind of take advantage of the opportunity. So that's chapter 8.

Starting point is 00:20:05 It's all about Mr. Market. It's understanding that you're being offered opportunities at every single day, there's an opportunity because every single stock is priced at a different level and all these different emotions. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is.

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Starting point is 00:24:26 Back to the show. Yeah, now I just want to ask you a quick question here, Preston, because this is a very public question. So giving what you have told us about Mr. Margaret. And I've heard you can't time the market. So are the two opposites as a paradox or other two different things? I don't see that as being two different things at all. So my opinion is you're not timing anything. What you're doing is you're looking at all the different opportunities that exist at time now. So as I look at a bond, 10 year treasury, there's all sorts of different bond. you got federal bonds, you got corporate bonds, you got munis, you got all these things that all have

Starting point is 00:25:06 a different level of risk. But if I was going to do it, what Buffett would describe as a zero risk investment, that's the 10-year treasury. That's giving me a 1.7 percent return or somewhere around in that ballpark. When I look at the U.S. equity market, it's almost, it's at 17,900 on the 26th of April when we're recording this. That for me is very high. I bet when you figure out what return that will give you based off the new earnings, you're

Starting point is 00:25:35 at about a 4% return where it's been for the last year. Ever since we've been recording this podcast, it's been about a 4% return. It hasn't really moved very much. So when I'm comparing those two, this is the key point. The yields are drastically different. One's giving you double the return of the other. But you have a lot more risk associated with one versus the other. So now you have to ask yourself, and this is where it becomes different for each person, and every person's going to see this differently, is the extra risk associated with owning a stock worth the extra 2% return that I'm receiving compared to a fixed income, zero risk investment?

Starting point is 00:26:16 We were talking about inflation is impacting bonds completely. So if inflation, where's inflation at right now? stick 1.7. It's about the same yield as the 10-year treasury. So that now takes my return on the, on the fixed income bond down to zero. And then I have to say that some of that is actually impacting the stock as well. Now, it wouldn't be the whole 1.7 percent. It might be half of that or something. So now you're really looking at a 0% return to a 3% return. This is my thought process as I'm going through that. So then I say is 3%, and I'm looking at it in kind of real terms here, is 3% worth my risk of owning the stock market right now, fully knowing that everything's pretty much being

Starting point is 00:27:04 manipulated by central banks at this point. And I would say, maybe not. I mean, that's really kind of a hard question. And I think that it's not something that I can really say with a lot of confidence that I feel one way or the other. I just think that there's a lot of risk in equity markets just because of how much they've been manipulated. When I look at how equity markets have been, and I'm talking about the stock market, when the stock market has been completely manipulated through quantitative easing, those are the things that I think about, from a macro standpoint to a micro standpoint, to timing the market, which Stig's really kind of getting to with this question,

Starting point is 00:27:36 I look at it from, what are my other options? You better believe I'm constantly looking across that array of choices, whether it's fixed income, equities, commodities, currencies, what's going to give me the best return at any given point in time, and then I'm making that choice. I'm not timing anything. I'm just looking at what's going to give me the biggest yield. Yeah, and I'm really happy you said that, Preston, because when people listen to on the podcast, hopefully they won't be thinking, okay, so what Preston and Stake is talking about is that if the Japanese central bank does this, then this will have an influence on my portfolio.

Starting point is 00:28:13 That's not what we're saying, and that we definitely don't want to time the market like that. What I'm saying and what Preston is saying is that, okay, so when you're buying a car, what's the value of that car and what's the price of that car? And that's what we're doing with stocks. We don't think about what would the stock market do tomorrow. And I think a lot of people are overthinking the question of can you time the market? You probably shouldn't be thinking like that. You should be thinking, what does it cost and what's the value? And just stop your thought process there. And if you find good bargains, you'll probably be better often and time will really take care of the rest for you. And it really gets back to the fundamental thing that Graham's talking about in this book is, are you speculating or are you investing? Because if you're investing, you're protecting your principle. You're putting your money into things that you have no idea how it could go wrong. That's investing is when you're saying, hey, this looks like a very good sound investment that has good consistent returns over time. That concludes chapter eight. Let's go to nine through 19 and kind of hit some of the high points here. So if we should label chapter 9 to chapter 19, it's really about how to find the right stocks. And Benjamin Graham, he's much more specific in these chapters compared to the first seven chapters of which criteria should you set up. But the first thing, Prest and I would like to talk about is him explaining what is a discount rate and what is normalized earnings. And why is that important in determining the intrinsic value of a stock? So the thing that I was kind of surprised with in getting kind of to what Stig's referring to here with the discount rates.

Starting point is 00:29:47 And when you're reading security analysis, which was his big first textbook, a lot of it was all about fixed income bonds. I'd say what, the first 25 chapters are almost all about bonds and fixed income investments. With this book, with the intelligent investor, it's really kind of focused towards common stock. And really kind of, there's some discussions about bonds, but really he's, he's talking a lot about stock investing. And so he does not come out and say, this is how you calculate the intrinsic value of a stock. He doesn't do that. But what he does do is he talks about a discount rate.

Starting point is 00:30:21 And he talks about really kind of just looking at multiples of earnings to price. And so let's talk about intrinsic value and discount cash flow and all that kind of stuff. So when you talk about free cash flow of a business, that is the cash that's the cash that's left after everything's paid for and it's the cash remaining in the bank account. This number is so important because at the end of the day, the money that the company brings in at their top line, their revenue, where that's what it's referred to, the sales revenue, there's different terminology and that's where accounting kind of gets a little bit confusing because you hear people throw around these terms and sometimes they mean the same thing. But your top line that if you had a,

Starting point is 00:31:06 let's just say your business was selling pepsies and you charge $1 for a drink just to make the number is easy. That $1 that you would receive is called the revenue or the sales. That's your top line. Whenever we say top line, that's what we're referring to. That's the $1. Then after you'd pay your employees, you'd pay for the metal in the can, you'd pay for the sugar, you'd pay for all the ingredients that make the drink, all that stuff, you pay your taxes.

Starting point is 00:31:32 After all that stuff is stripped away from that $1 in that sale, that top. line number, you get to your bottom line, which is your net income. And that number might be 10 cents. And that would make your 10% margin. That's what we're talking about is that top line to bottom line number of what the company's able to retain from their sale. So when you talk about free cash flow, you're really kind of getting into that bottom number, that net income, but you also have depreciation. You've got all these other things that you're accounting for, but you're eventually coming to what is the company able to retain in cash? after everything is set and done.

Starting point is 00:32:09 And that's the number that's important for determining the value of the business over time. So when we look at the company's free cash flow, let's say that we're just going to talk whole numbers of a business. Let's say that a company is able to have a million dollars in free cash flow this year. And then they had $900,000 of free cash flow last year.

Starting point is 00:32:32 And the year before that, they had $800,000 of cash flow. So you can kind of see the trend here. is that the company is basically adding $100,000 of cash flow every year. That's a good thing. That's trending in a good direction. That's what you're wanting to see when you're looking for a business is determining that free cash flow. So when you see that and there's no guarantee, there's absolutely positively no guarantee that that company will have that kind of cash flow moving into the future.

Starting point is 00:33:00 But what you're looking for is a business that has some type of sustainability, stability to it, that gives you a reasonable expectation that in the future you could expect the same results. So one that Stig and I really like to use is Coca-Cola. This is a company that has pretty stable results. You can go back now. There's going to be some fluctuations here and there. But as you, the listener, listening to this, is your expectation that next year Coca-Cola is going to continue to sell just about the same number of soft drinks?

Starting point is 00:33:32 If the answer is yes, then that's the kind of company that we're talking about that you can reasonably assess the value of it. Now, if you were going to say, think of a business that you think would be really volatile, that you would say, yeah, they made a lot of money this year, but maybe next year, I'm not so sure they could maybe pull that off again. Those are the companies that Buffett doesn't even try to figure out the value of, or Benjamin Graham try to figure out the value of, because it's really kind of hard to put a value on it.

Starting point is 00:33:59 Now, if the price is low enough, yeah, they'll try to value it. But for the most part, they're trying to find that steady, stable business. business that they can actually determine and say, hey, I think over the next 10 years, they're going to continue to have this kind of free cash flow. And because of that, they feel like they can have a lot of confidence in their ability to take those, add up all those cash flows, and then discount them back to today's present value to try to determine what the value is. So when we talk about a discount rate, this is the thing you got to understand. When you add up all your future cash flows, so let's just say next year you're going to earn a million. The year after that, you'll earn a million

Starting point is 00:34:37 and you go 10 years into the future. So you're going to make 10 million dollars over the next 10 years, but what's that 10 million dollars spread across the next 10 years into the future worth today? That's the key thing you've got to figure out. What's it worth today opposed to the value 10 years from now? So in order to figure that out, you need what's called a discount rate in order to calculate what it is today. We have this. in all of our books. We talk about this on Buffett's books. In fact, we have a calculator that automatically figures this out for you on Buffett's books. We'll have a link forward in the show notes if you want to go play around with it. But what you're doing is you're adding up all those

Starting point is 00:35:16 future cash flow as you're using a discount rate. And so the discount rate that you typically use, or that Buffett recommends that you use, is the 10-year treasury. So when you discounted back at whatever interest rate you choose, and I think the starting point is always the 10-year treasury, you bring that back, it's going to say that the stock is worth $100 or $50, and you obviously have to divide out the number of shares outstanding. So this is kind of a process, if you will, and we have videos. We have detailed videos that teach people how to do this. And to be honest with you, Graham doesn't get into this level of valuation in his book. He talks about it. He says, you need to do a discount analysis. You need to figure out what

Starting point is 00:36:00 the present value is today based off of the expectation of the company to earn in the future. But he doesn't get into these equations. He doesn't get into the math behind this. And that was one of my frustrations with this book because I wanted to get into that. I think for a lot of people out there, they hear the discussion are like, well, okay, well, how do I do this? Yeah, you're definitely the right, Preston, because we're all looking for that one formula that can just tell us what intrinsic value is and let us compare that to the current market price. But unfortunately, it's not that simple. So we talk about the discount rate first. How I teach my students to look at this is I'm teaching them about the opportunity cost, first of all. So the opportunity cost is really

Starting point is 00:36:40 important. That's also why Warren Buffett uses the 10-year treasury, because that is an opportunity cost of a risk-free investment. Intuitively, that's also why you would rather want one dollar today than in a year, because you would have the chance to invest that dollar and get a return from that over that one year. Another thing to include is inflation. If we have a high inflation, we would everything else demand a high return on our capital. I also think it's important to look at risk and compare that to the discount rate that you're using. And the hard thing about is that there are no finite number that we can just say this is the perfect measure of risk. And I think one of the best examples I come up with is that a lot of people have approached

Starting point is 00:37:25 mean want to help me raise capital to their startup company. And whenever you are in such a process and you would usually issue shares to raise capital, you would have to consult with them about so what do they think their company is worth? How do they come up with the valuation of the company? This all come back to discount rates because they were showing me all these graphs and all these prospects of how much money they will make. And that might be all right. But it's extremely risky, it extremely uncertain, and even the highest cash flows, when you discount that with the appropriate discount rate, if it's a risky company like a startup, you'll just see that is completely reflected in the intrinsic value. So if it helps for people to understand,

Starting point is 00:38:09 look at the discount rate and the earnings or the cash flows that President was talking about before as two sides of the same coin. You have the normalized earnings, but they have to be discounted, giving the risk, inflation, and opportunity cost. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together

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Starting point is 00:41:20 total return since inception is 7.8%. Past performance does not guarantee future results, current distribution rate as of 1231, 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income fund fund's prospectus at fundrise.com slash income. This is a paid advertisement. All right, back to the show. So let me talk about where I kind of have a different opinion than Buffett and not necessarily Graham, because Graham doesn't necessarily say that it needs to be a 10-year treasury used as the discount rate. That's much more Buffett that's saying that.

Starting point is 00:42:00 I disagree with Buffett on that. I think that the discount rate should actually be the current yield of the S&P 500. That's what I think should be used when you're comparing an individual stock pick. And the reason that I have that is because, or the reason that I have that, or the reason that I have that opinion is because of this. If I go and I take an individual company and I use, in today's example, the 10-year treasury is 1.7%. That's going to give me a much higher intrinsic value of a stock using a 1.7% discount rate than using what we think the current S&P 500's yield is, which is 4%. So if I use 4% compared to an individual company, I'm actually going to get a

Starting point is 00:42:41 lower intrinsic value on that business because I used a higher discount rate. Now, the reason why I'm saying use the S&P 500 is because if you took an individual stock and you compared it to the S&P 500 and you made both of them have the same yield in this example of 4% discount rate, I'm going to tell you every single day of the week that the S&P 500 is lower risk than an individual company. So why in the world would I use a discount rate of the 10-year treasury when I could be using something that's giving me a more matched, if you will, risk and more conservative price estimate by using the current yield of the S&P 500? I think that that's a much more appropriate discount rate that's giving you a much more conservative estimate. That's an apples to apples kind of estimate, A, because you're using equity.

Starting point is 00:43:36 and B, because you're actually getting a much safer or much more appropriate risk appetite comparing a basket of 500 stocks to an individual stock pick. That's my opinion. I'm curious to hear what Stick thinks about that idea. Well, that thing is a good point that you have, Preston. And I also thought about, so if we do use the 10-year treasury, does that mean that there is no risk in anything because it's so low? I can see that the interest rate would work in some territories, but it doesn't work today.

Starting point is 00:44:08 And perhaps at the time Warren Buffett was saying it, it might be taking out of context, and the interest rate might be a lot higher. So I just think if we return to what you said before, Preston, when you said 4% for the SPR102% for the treasury, it doesn't mean it's just twice as good. The best way for me to explain this is that you will hear about if you eat this, you will have a 30% higher chance of this disease. That might be right, but a 30% increase of nothing, it's still nothing. I think that would be my take in terms of explaining what is the opportunity cost here,

Starting point is 00:44:43 because I'm looking at this as opportunity cost. And if you're just picking an individual stock, obviously there could be a management issue or that could be like something catastrophic happen to this company. But if you own S&P 500, you own like all the companies and you don't have to spend time on it. So I definitely see where you are when you're coming from. Yes, Preston. Where this idea kind of originated with was I would get frustrated because people would go and use the intrinsic value on our Buffett's book site. And I would get these emails and all these messages from people. And they'd, they would do the analysis. They would calculate the value and they'd be using the 10-year treasury. And it was like yielding, you know, 1.7 percent. And they're figuring out the intrinsic value of these companies using a 1.7 percent discount rate because that's the way Buffett says. And they'd be getting these really high market prices for different companies. Because This is the easiest way to understand it. The lower that that discount rate goes, the higher your intrinsic value number is going to be on the company.

Starting point is 00:45:39 So as these interest rates continue to be manipulated by these central banks and it gets pushed closer and closer to zero, the intrinsic value of all these stocks just get pushed to the moon. You know, I mean, they just go through the roof. And so I'm looking at that. And a person would be saying, yeah, so company XYZ is worth $1,000 a share discounted at a 1.7% discounted at a 1.7% discount rate. And I'm thinking, oh, man, yes, yes it is, but you're not accounting for the fact that with the Treasury, you're going to get your money, no matter what, the federal government's going to pay that back. You're going to get the coupon. With the company, you have no,

Starting point is 00:46:17 there's tons of risk that the company might not be able to hit those earnings. And then you're only discounting it at 1.7%, which is giving you this crazy price. So that's whenever I was like, there has to be a better discount rate than the 10-year Treasury that's reprimed. representative of A, an equity to equity, because I'm going to totally geek out on you, but when you're talking about a bond, you're talking about a finite financial instrument. It's something that will mature on a fixed date. When you're talking about an equity, it's something that goes into perpetuity. So you're already comparing apples to oranges as far as I'm concerned, because you're comparing a finite instrument to an infinite instrument when you're talking equities and

Starting point is 00:46:55 fixed income. So I wanted something that was different than that, that compared apples to apples, equities to equities, if you will. And I also wanted something that had that compared a stock to a stock, but it was also taking into account the risk appetite. So for me, when I look at the S&P 500, if you can't match that, if you can't match that price, in fact, if you can't beat that price, why in the world are you taking an individual stock pick over the S&P 500 if you can't beat it? And so that's why I like using the current yield off the Cape Schiller. I know that, the people listening to this might be frustrated. I think there's a few people out there that are listening to this that are maybe really enjoying the conversation because we are really getting

Starting point is 00:47:38 into the weeds on some hardcore finance and accounting type stuff. But this is really important if you're a person that's actually calculating values of businesses and not just kind of selecting things on an emotional level, but you're actually doing some math to figure things out. And to be honest with you, one of the first things that Graham talks about in this book is if you're an investor and you're figuring out the value of something, there needs to be math associated with what you're doing. And so that's why we're really kind of going down this path and talking about the math behind determining the value of a company. Yeah. And just in continuation of that, Preston, I'm sure you're experienced the same, but I get so many emails that talks about the intrinsic

Starting point is 00:48:19 value. And I also have a lot of emails from people saying, could you discuss that more in the show? So good news and bad news. We just did that and you just saw how complicated it is. And also, I also want to say it has something to do with the podcast medium because we thought about this many times before. Should we talk more about intrinsic value? And you can just hear that when we're talking about this, we're talking about graphs, we're talking about math. A podcast is just a really hard medium to explain that.

Starting point is 00:48:45 And if I could just come with another example. So if you look specifically in the intelligent investor, then Benjamin Graham would say you can use these rule of thumbs when you're looking at earnings. You will look at those from the past seven to ten years. And then you would weigh them differently compared to how. long it has been since they have these earnings. Now, I'm sure a lot of people would understand what I said here, but it's not difficult to explain, but it's difficult to illustrate and to simplify speaking on a podcast. So I guess that would be my disclaimer for not doing it before.

Starting point is 00:49:15 So if you're really frustrated about this conversation, don't worry, as Preston said before, we have some videos that actually illustrates this. It's not because we don't want to talk about on the podcast, but it's a hard medium to do so. Yeah, definitely go to the show. If this stuff piques your interest and you want to learn more about it. Go to our show notes. We have links to the intrinsic value calculator, which has the videos on the same web page that teaches you how, where to find the data, to plug into the calculator, how to think about some of this stuff. We got all that on the website. So just go to the show notes. So we're going to skip over a bunch of the stuff between those chapters and go right

Starting point is 00:49:50 to chapter 20, which is a really important discussion. One of the chapters that Warren Buffett said that we need to focus on in the intelligent investor. And that's the discussion about margin of safety, and how important this is to investing. So the best example that I think Buffett provided that people can easily conceptualize and think about is the idea of a truck crossing over a bridge. So Buffett says if you're going to build a bridge that can support 10,000 pounds and drive across the bridge, how strong would you build the bridge? Would you build it so that it was 10,001 pounds that it would support?

Starting point is 00:50:27 or would you build the bridge so that it could support 15,000 pounds? And it's such an easy discussion for people to have, but it doesn't necessarily have an answer. It's really kind of up. I mean, if I was the person building the bridge, I'd say, okay, what confidence level do we have that the truck's going to weigh 10,000 pounds? What kind of weather are we going to have and what kind of environmental situations do we have in this area where the bridge is going to be built? There's all these different considerations, but at the end of the day, you're going to kind of make a swag, if you will, as to what margin of safety you're comfortable building the bridge at.

Starting point is 00:51:07 So, you know, off the top of my head, I'd say, yeah, we'll build it for 15,000 pounds. If the heaviest vehicle going over, it should be 10,000. That way you have your margin of safety. So when it comes to investing, it's the exact same thing. If you're wanting to buy a company and you can get a 2% return on a 10-year treasure, and a company is priced at a 2% yield, it's a no-brainer. You buy the 10-year treasury because the yields are the same. And this is assuming that inflation is nothing, just for ease.

Starting point is 00:51:39 So that's an easy decision because the bond is a lot lower risk than the equity or the stock. And that's where he's getting into this margin of safety. So how much above that 10-year treasury price or above the yield you'd expect to get out of the S&P 500, how much above that do you need in order to make a selection on an individual stock pick? So if you're out there and you're calculating the intrinsic value of general electric, and I don't know what the intrinsic value of general electric is, but let's just say that you determine it is 5% or 6%. Is that margin, that 1 or 2%, is that extra 1% or 2% above the S&P 500 giving

Starting point is 00:52:21 you a 4% return worth your risk? I can't answer. that? I don't know. That's completely up to you to determine what that margin of safety needs to be in order for you to make that selection. But that's what Buffett's getting into here, where you're jumping from one risk scale to the next, where S&P 500 is lower risk than the individual stock pick, and the 10-year treasury is less risk than the S&P 500. You have to make that determination of where you're satisfied, assuming more risk for the yield that you're potentially going to get, and that's a keyword potentially going to get. And it's really kind of up to you to determine. But I think the discussion, and for a lot of people, just thinking of things in that context is a really important

Starting point is 00:53:06 thing. So Stig, I'm curious to hear your thoughts on this margin of safety stuff. Well, I think I agree with you, Preston. Actually, if you saw, I was eager for saying something, it wasn't so much about the margin of safety. It's one of those things that either you get it or you don't. I think the vast majority of people out there, they'll be saying, hmm, rich, 10,000 pounds, 15,000 pounds, it makes a lot of sense. And then you have other people in them might not listen to this podcast saying, oh, so I saw that the stock was down 4% yesterday, so it's probably going to bounce today. I mean, it's just different ways of looking at stocks. And if you accept the whole notion above that price and value is two completely different things, I think the margin of safety

Starting point is 00:53:51 concept is extremely powerful, but also the thing is so simple that if you have the right mindset, you could probably have figured the whole thing out faster that we could explain it, because it's just so obvious. But if I should talk about the intelligent investors in general and what I was missing, because I would really like a discussion about competitive advantage. And for anyone who knows about Benjamin Graham, I would be saying, stick, that doesn't make any sense, that you say that because Benjamin Graham, he is very conscious to him. He is not saying this company would do well because they have valuable and changeable assets, or he would not be saying this company would do well because they have a strong brand.

Starting point is 00:54:29 That's not his type of investing. Just want to throw that out to you guys out there. If you're looking for the one book and you heard about everyone saying you should be the intelligent investor because that's where you can really shape your investment philosophy, then I'll say yes, the latter is true. This book is vital to you shape your investment philosophy just as it did with Warren Buffett. But still, if you want to do active investing, and if you want to do active investing like Warren Buffett is doing, then you also need to have the qualitative part included.

Starting point is 00:54:59 And I think that was something I was missing from this book. So, guys, that kind of wraps up our summary of the intelligent investor. One of the things that I wanted to throw out there to our audience, Stig and I are kind of working on creating more value for our audience, building new things into our website and things like that. So one of the things that we talked about a few times on our show is when we look at our own personal business, we kind of break it into two different segments. You've got the operational side where you're creating assets, kind of like this podcast. This is an asset for us. That's creating a cash flow for our personal business. You might have a business of your own.

Starting point is 00:55:41 You might have a brick and mortar store. You might have a digital online store, whatever it is. that's creating a cash flow for yourself. Once you create that cash flow, you then have to be able to invest the retained earnings of that cash flow. And that's what we're typically talking about on our show is that second part where what do you do with this money once you have it, whether it's your salary, whether it's your own business. And like today, when we're talking about investing in stocks, we're talking about how do

Starting point is 00:56:07 you take that cash flow and purchase another asset that somebody else has created in order to own a proportional piece of equity in that business. What we're trying to do is talk to people and maybe teach people how to do that first part where you're creating online assets or you're creating equity in some type of business or you're doing something that's creating a cash flow stream for yourself. And so in order to do that, what we've done is we've bought a domain that's going to point you back into the Investors podcast website. but we're trying to create videos and tutorials in order to teach people how to create income,

Starting point is 00:56:48 specifically passive income, because that's what we're, that's what a lot of our assets are, for yourself. And so we've purchased the domain, create passive income. If you type that into your web browser, create passive income, it's going to take you to a page where we're creating tutorials and video courses for people to learn passive income investing, stock investing, all sorts of things. But if you go there to create passive income, you're going to be able to see some of the products that Stig and I are building. So one of the products that Stig just recently built is a chapter by chapter video course of the intelligent investor. So let's just say you go out and you buy this book that we just got done discussing and you're going through it and it's difficult

Starting point is 00:57:31 for you to understand. Stig created a chapter by chapter course, video based course, where he teaches literally every chapter of this book. So if that's something you'd be interesting, go to create passive income.com and you can see the course that Stig built. We're actually creating other courses. I'm in the process. I'm a little bit slow. I'm not as quick as Stig, but I'm in the process of building a course on how to stand up and create your own podcast. So if you'd like to do maybe you, maybe you're a specialization in hunting or whatever it is, I don't know.

Starting point is 00:58:08 And maybe you want to create your own podcast and talk about this kind of. of stuff. I'm trying to create a tutorial video that shows you all the equipment we use, kind of how we do our show, all that kind of stuff. But that's something that we're trying to build out for our community so that you can start creating different online assets, digital assets for yourself. If that's something you want to do, if not, no sweat, you can just completely ignore all of that. But I wanted to throw that out there for people so that they know that it exists. So that concludes our episode for this week on the intelligent investor. hopefully you guys enjoyed our conversation.

Starting point is 00:58:42 We apologize if we got a little too technical over the audio format. But if we did and you want to see more stuff on video, we got the Buffett's books tutorials, which are completely free. All the calculators, all that stuff is free. And we'll have links in the show notes for that. So thanks for joining us this week and we'll see you guys next week. Thanks for listening to The Investors podcast. To listen to more shows or access to the tools discussed on the show,

Starting point is 00:59:07 Be sure to visit www. TheInvesterspodcast.com. Submit your questions or request a guest appearance to The Investors Podcast by going to www.w.com. If your question is answered during the show, you will receive a free autographed copy of the Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before

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