How Warren Buffett Evaluates A Business

I like to study Warren Buffett recent investments. He knows how to dissect different type of fundamental information from a company and create an investment thesis based on concepts that everyone could understand. In most cases these concepts are just common sense information. Warren Buffett is an expert on simplifying complex financial data and invest around that. For example, the concept of “moat” is fantastic and he has done a great analysis at evaluating a company’s management team.

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Warren Buffett is a truly long term investor that doesn’t care paying attention to technical information. I disagree on that. I believe that it is better to learn to invest using the best fundamental and technical information available and focus on the very best growth companies. I like to buy corporations that lead their particular industries in sales, earnings, profit margins, and return on equity. In other words, buying companies that are gaining market share on their competitors.

These kind of companies are called ‘Growth Stocks’ and show consistent earnings and sales growth, usually 20% or more each year for the past three or five years. The P/E of growth stocks are generally higher than those of the average stock simply because they have a record of better than normal earnings growth. While Warren Buffett would have missed lots of these absolutely outstanding companies during their period of greatest performance (think of Apple, Google, Chipotle Mexican Grill, etc), I think that it is very interesting to study his methodology to analyze fundamentals and the things he pays attention. One book I recommend is The Warren Buffett Way, from Robert Hagstrom. From there and other research I took the most imporant things Warren looks when he evaluates a business:

Analysis related to the overall business

Simple and Understandable

In Buffett’s view, an investor’s financial success is in direct proportion to the degree to which he or she understands the investment. Buffett is acutely aware of how the business he will invest operates. Buffett is able to maintain a high level of knowledge about Berkshire’s businesses because he purposely limits his selections to companies that are within his area of financial and intellectual understanding. “Invest within your circle of competence”, he advices. “An investor needs to do very few things right as long as he or she avoids big mistakes”. Above-average results, Buffett has learned, are often produced by doing ordinary things. The key is to do those ordinary things exceptionally well.

Consistent Operating History

Buffett avoids the complex. It has been his experience that the best returns are achieved by companies that have been producing the same product or service for several years. Undergoing major business changes increases the likelihood of committing major business mistakes. Buffett experience has taught him that “turnarounds”seldom turn (think on Research in Motion, Dell, Yahoo, etc right now). What is essential is that he thinks is better to buy good businesses at reasonable process than difficult businesses at cheaper prices.

Favorable Long Term Prospects

According to Buffett, the world is divided into a small group of franchises and a much larger group of commodity businesses, of which most are not worth purchasing. He defines a franchise as a company providing a product or service that is 1)needed, 2)has no close substitute, and 3) is not regulated. Economic strenght is most often found in franchises. One strenght is the potential to freely raise prices and earn high rates on invested capital. Warren Buffett looks at companies that can keep expaning, like Coca Cola and IBM in emerging economies for the foreseeable future.

Elements related to the company’s management

Rationality

Warren Buffett studies how management allocates the company’s capital. This is essential because allocation of capital, over time, determines shareholder value. A company that provides average or below average investment returns but generates cash in excess of its needs has three options: 1) It can ignore the problem and continue to reinvest at below average rates, 2) it can buy growth, or 3) it can return the moeny to shareholders. It is at this point that Warren focuses on management behavior. It is here that management will behave rationally or irrationally.

Buffett loves when a company repurchases stock and he explains that when executives actively buy the company’s stock in the market, they are demonstrating that they have the best interests of their owners at hand, rather than a careless need to expand the corporate structure.

Candor

Buffett respects managers who report their companies financial performance fully and genuinely, who admit mistakes as well as share successes, and are in all ways candid with shareholders. Buffett always says that “The CEO who misleads others in public”, he says,  “may eventually mislead himself in private”.

Buffett always say that no matter how impressive management is, he will not invest in people alone. “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics”, he writes, “it is the reputation of the business that stays intact”.

Elements related to the company’s financial statements

Return on Equity (ROE)

For Buffett, the primary test of managerial economic performance is the achievement of a high earnings rates on equity capital employed and not the achievement of consistent gains in earnings per share. To measure this Buffett prefers to use return on equity- the ratio of operating earnings to shareholder’s equity.

Buffett believes that a business should achieve good returns on equity while employing little or no debt. Companies can increase their return on equity by increasing their debt-to-equity ratio but good business or investment decisions will produce quite satisfactory economic results with no aid from leverage.

Buffett looks for companies that operate with low debt levels and a ROE above 17%.

“Owner Earnings”

Warren Buffett looks at what he calls ‘Owner Earnings’ and others call ‘free cash flow’. Buffett prefers to take a company’s net income plus depreciation, depletion, and amortization, less the amount of capital expenditures and any additional working capital that might be needed.

In other words, Warren looks at operating cash flows but he then subtracts the required capital expenditures to run the business and the results is what he calls owner earnings.

Profit Margins

In Buffett’s experience, managers of high cost operations tend to find ways to continually add to overhead, whereas managers of low-cost operations are always finding ways to cut expenses. Warren looks for companies with superior profit margins and has little patience for managers who allow costs to escalate.

Warren looks for management teams that are shareholder oriented by increasing profit margins while decreasing costs.

Conclusion

The most distinguishing trait of Buffett’s investment philosophy is the clear understanding that, by owning shares of stock, he owns businesses, not pieces of paper. “Investing is most intelligent when it is most businesslike”. These words are, Buffett says, “the nine most important words ever written about investing”.

When Warren is asked what types of companies he will purchase he says that he will look for a company that he could understand, one that posses good economics and is run by trustworthy managers. He will also avoid commodity businesses.

I think that it is key to select strong fundamental companies (like Buffett does) and buy them at the time they emerge from a consolidation period and starts a trend (using solid technical analysis tools).

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