More Praise for The Warren Buffett Way, First Edition

Security Analysis,
was “that value which is determined by the facts.” These facts included
a company’s assets, its earnings and dividends, and any future definite
prospects.
Graham acknowledged that the single most important factor in de-
termining a company’s value was its future earnings power, a calculation
that is bound to be imprecise. Simply stated, a company’s intrinsic value
could be found by estimating the earnings of the company and multiply-
ing the earnings by an appropriate capitalization factor. The company’s
stability of earnings, assets, dividend policy, and f inancial health inf lu-
enced this capitalization factor, or multiplier.
Graham asked us to accept that intrinsic value is an elusive concept.
It is distinct from the market’s quotation price. Originally, intrinsic
value was thought to be the same as a company’s book value, or the sum
of its real assets minus obligations. This notion led to the early belief that
intrinsic value was definite. However, analysts came to know that the
value of a company was not only its net real assets but also the value of
the earnings that these assets produced. Graham proposed that it was not
essential to determine a company’s exact intrinsic value; instead, in-
vestors should accept an approximate measure or range of value. Even an
approximate value, compared against the selling price, would be suffi-
cient to gauge margin of safety.
There are two rules of investing, said Graham. The first rule is 
don’t
lose.
The second rule is 
don’t forget rule number one.
This “don’t lose”

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T h e E d u c a t i o n o f W a r r e n B u f f e t t
1 5
philosophy steered Graham toward two approaches for selecting common
stocks that, when applied, adhered to the margin of safety. The first ap-
proach was buying a company for less than two-thirds of its net asset
value, and the second was focusing on stocks with low price-to-earnings
(P/E) ratios.
Buying a stock for a price that is less than two-thirds of its net assets
fit neatly into Graham’s sense of the present and satisfied his desire for
some mathematical expectation. Graham gave no weight to a company’s
plant, property, and equipment. Furthermore, he deducted all the com-
pany’s short- and long-term liabilities. What remained would be the net
current assets. If the stock price was below this per share value, Graham
reasoned that a margin of safety existed and a purchase was warranted.
Graham considered this to be a foolproof method of investing, but
he acknowledged that waiting for a market correction before making an
investment might be unreasonable. He set out to design a second ap-
proach to buying stocks. He focused on stocks that were down in price
and that sold at a low P/E ratio. Additionally, the company must have
some net asset value; it must owe less than its worth.
Over the years, many other investors have searched for similar short-
cuts for determining intrinsic value. Low P/E ratios—Graham’s first
technique—was a general favorite. We have learned, however, that mak-
ing decisions on P/E ratios alone is not enough to ensure profitable
returns. Today, most investors rely on John Burr Williams’s classic defi-
nition of value, described later in this chapter: The value of any invest-
ment is the discounted present value of its future cash f low.
Both of Graham’s approaches—buying a stock for less than two-
thirds of net asset value and buying stocks with low P/E multiples—had
a common characteristic. The stocks that Graham selected based on
The basic ideas of investing are to look at stocks as businesses,
use market f luctuations to your advantage, and seek a margin
of safety. That’s what Ben Graham taught us. A hundred years
from now they will still be the cornerstones of investing.
4
W
ARREN
B
UFFETT
, 1994

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1 6
T H E W A R R E N B U F F E T T W AY
these methods were deeply out of favor with the market. Some macro-
or microevent caused the market to price these stocks below their value.
Graham felt strongly that these stocks, priced “unjustifiably low,” were
attractive purchases.
Graham’s conviction rested on certain assumptions. First, he be-
lieved that the market frequently mispriced stocks, usually because of the
human emotions of fear and greed. At the height of optimism, greed
moved stocks beyond their intrinsic value, creating an overpriced mar-
ket. At other times, fear moved prices below intrinsic value, creating an
undervalued market. His second assumption was based on the statistical
phenomenon known as “reversion to the mean,” although he did not use
that term. More eloquently, he quoted the poet Horace: “Many shall be
restored that now are fallen, and many shall fall that now are in honor.”
However stated, by statistician or poet, Graham believed that an investor
could profit from the corrective forces of an inefficient market.
P H I L I P F I S H E R
While Graham was writing