The Education of Warren Buffett 15philosophy steered Graham toward two approaches for selecting common
stocks that, when applied, adhered to the margin of safety. The f irst 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
f it neatly into Graham’s sense of the present and satisf ied 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 f irst
technique—was a general favorite. We have learned, however, that mak-
ing decisions on P/E ratios alone is not enough to ensure prof itable
returns. Today, most investors rely on John Burr Williams’s classic def i-
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
WARRENBUFFETT, 1994