Image source: The Motley Fool
In the world of investing, few have gained legendary status like Warren Buffett. Starting with a small sum at the age of 11, the ‘Oracle of Omaha’ is one of the wealthiest people on the planet, with his fortune almost entirely made from the stock market.
As a result, Buffett serves as an excellent case study for new investors looking to refine, or develop their skills and knowledge. And luckily, the billionaire has been incredibly open about his approach and strategy, with new nuggets of information dropped each year in his annual letters.
Let’s explore some of the key takeaways and why buying dirt cheap UK shares today could be the key to unlocking vast wealth in the long run.
Price versus value: what’s the difference
A common mistake new investors make is to assume that a stock trading at a higher price is expensive. That might be true. However, it may be possible for stock trading at even £100 a share to be cheap. How’s that possible?
Whether or not a stock is considered cheap depends on the share price versus the intrinsic value of the underlying business. At a share price of £100, company X could be a bargain if the business behind it is actually worth £150. Similarly, a penny stock trading at 20p could be absurdly expensive if the company’s worth only 5p.
The way Buffett describes this is “price is what you pay, value is what you get”. And by exploiting stocks trading at prices well below their true value, he has made billions.
Calculating intrinsic value
Unfortunately, determining the precise amount a company is worth is nearly impossible. That’s because every valuation is based on a set of assumptions about a firm’s future performance, which may never come to pass. Even with his skills and experience, Buffett’s best efforts are still estimates. And he has also made mistakes along the way.
Estimating a stock’s worth is no easy task, often requiring complex mathematical models. But a shortcut would be to use the P/E ratio. By comparing this metric to the industry average, investors can determine whether a stock is trading above or below its peer group, sparking an investigation as to why that might be the case.
This relative approach is quite rough. And under normal market conditions, it’s not the best at identifying buying opportunities. But 2023 isn’t experiencing normal conditions.
The continued pressure of inflation and interest rates has triggered a lot of uncertainty and doubt. This leads to panic selling that sends the stock market into a tailspin like we saw in 2022.
But as Buffett puts it: “Be greedy when others are fearful”. During volatility, investors make the most mistakes, selling off terrific companies even at terrible prices.
But for the brave few who can spot these bargains, enormous wealth can be unlocked when the shares eventually recover and potentially go on to reach new record highs.