The Business of Value Investing: Six Essential Elements to Buying Companies Like Warren Buffett

Chapter 5. Develop a Search Strategy: THE SECOND ELEMENT

A public opinion is no substitute for thought.

—Warren Buffett

There are thousands of publicly traded companies in the United States and thousands more throughout the world. Searching for stocks is both interesting and daunting. The quest for the "next great stock" has become the holy grail of investing. The truth is there are no great stocks, only great investments. What differentiates between the two? The price you pay. And how do you increase the likelihood of paying a sensible price for a share in a company? By making your investment decisions based on business fundamentals and nothing else.

A great business does not necessarily imply a great stock investment. Google is a fantastic business that generates tremendous profits. However, if you were buying Google at $700 a share and paying 42 times earnings, you weren't making a great investment. Remember the other way to look at the price to earnings (P/E) ratio is by inverting it to get the earnings yield. So for Google, a P/E ratio of 42 means you are paying $42 for each dollar of earnings. The earnings yield is the return you get based on the price you pay. For $42 you are getting $1, implying a yield of 2.4 percent ($1/$42). When Google was trading at these valuations, ultra-safe U.S. Treasury bills yielded over 3 percent. In other words, investors were willing to take less return by paying more in hope of a continual rise the in share price. You have no margin of safety ...