Investorial

Warren Buffett has some tips for you! And if you’ve been following our series on Buffett’s tenets, you’ve become a bit more familiar with what Buffett thinks about the market and what “qualities” he looks for in a business. Today, we go into more detail about the quantitative measures he examines in order to further his assertions of a company’s investability.

High Profit Margins
There are only 2 ways for companies to price their goods and services to make a profit. They could price it with a low-profit margin and rely on volume traffic, or they could price it with a high-profit margin and not worry as much about volume. Buffett realized that outstanding companies were able to enjoy a high-profit margin along with high volumes — the best scenario! As an owner-investor, Buffett would often look for companies that already have high-profit margin and by controlling its board, he’d improve the operations of the business to achieve that scenario. He loves companies that don’t have a pressing need to reinvest much precious earnings into capital expenditure. Companies who often incur high capital expenditures may encounter problems with a margin squeeze sometime down the road.

A side-effect of pursuing a high-profit margin company is that those companies usually turn out to be very lowly-leveraged. Buffett doesn’t want costs to be eaten by high interest for high debts. Whereas we are aware of the compounding benefits of high investment returns, the corollary is equally impressive in its destruction of profits via high interest costs.

Focus On Return On Equity, Not Earnings Per Share
Wall Street’s obsession with earnings-per-share (EPS) is not shared by the world’s greatest investor, so why would you join in the folly? Buffet considers return-on-equity (ROE) as a better measure of annual performance because it takes into consideration the company’s ever-growing capital base, the ratio of operating earnings to shareholders equity. Equity can best be explained when you think about the equity in your own home. Your home’s equity is its value less the mortgage still owing on it.

By looking at ROE, Buffett is able to determine how efficient the company is at using both shareholder’s capital and debt to produce income. It’s generally accepted that a ROE above 15% is a good sign. ROE is a readily available measure on financial sites such as Yahoo!.

And why is EPS a poorer indicator? A lot of noise gets built into the figure as analysts apply their ingenuity at predicting what number is appropriate for the next quarterly earnings report. Those differing opinions combined with the pressures on executives to deliver on guidances and numbers generate a mania that becomes a self-feeding and self-destructing cat-and-mouse game. Short-term fluctuations are not as important as comparing the ROE over the long term for a better analysis of the company’s long-term financial health. EPS also does not tell you whether those income were earned at the expense of rising debt. A company earning $100,000 with no debt versus a company that earned $200,000 with an additional $100,000 debt represents the same EPS figure.

Calculate “Owner Earnings” To Get A True Reflection Of Value
“Owner’s earnings” is a term coined by Buffett and it simply means the cashflow available to shareholders. Buffett loves companies that can generate more cash from operations than they need. These excess cash means that the business can fund future operations, expand in scale, and compound by reinvestment without resorting to leverage or borrowing. To determine owner earnings add depreciation and amortization charges to net income and then subtract the capital expenditures of the company. Normally, depreciation, amortization reduce the official version of earnings.

Buffett believes owner earnings give a more accurate picture of a company’s earning power than the amount reported on its income statement. Unlike the standard accounting numbers, owner earnings show you how much free cash a company can create, year after year, for its shareholders.

Buy Companies With Strong Histories Of Profitability; With A Dominant Business Franchise
A franchise in Buffett-speak is essentially a durable competitive advantage (DCA) — an edge that is difficult for competitors to duplicate and that isn’t going to go away any time soon. Investors often confuse DCA with having a brand name. While companies with DCA often are brand names, there are more brand names out there that don’t enjoy a DCA, and are fighting for that dominance. DCA can manifest itself with a company’s size, its marketing power and brand power that’s been built up over the decades. These companies could also be dominant continently, globally or entrenched in their own exclusive region.

Here’s a recent example of DCA in action, while Walmart is an absolute retail giant in North America, the truth is that they are having problems penetrating the retail sector in other areas around the globe. The evidence that Walmart had to exit its Germany businesses shows the lack of DCA in that region. However, Walmart can absolutely defend its territory in the United States where it enjoys the DCA that it’s built over the years.

Companies with strong history of profitability, and having a dominant business franchise have the advantage of being able to weather the storms that its competitors cannot. As such, the knee-jerk reactions of Wall Street towards bad news for these companies make them prime candidates for Buffett followers.

Determine The Intrinsic Value And Pay A Fair / Bargain Price
The critical investment factor for Buffett and many other value investors is determining the intrinsic value of a business and paying a fair or bargain price. However, there’s also a reason why this is the last quantitative measure mentioned because it’s often the last thing to consider for Warren Buffett. Though at times Buffett has made some deep-value plays (such as when he scooped up Coca-Cola for a song), Buffett’s evaluations are not merely price-influenced. Buffett has often said that “it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. Too often, investors see a company that is priced well below its book value; but picking up that stock without regards to its margin, return-on-equity, “owner earnings” and profitability history may prove to be a bad choice.

Buffett loves to compare the current “owners earning” yield (its ratio to the current stock p rice) to that of 10, 20, 30-year US treasury bonds. The rational is that if the yield cannot earn as much as less risky investments, then why take the risk?

The X-Factor: Next In The Buffett’s Tenets Series
So now that Buffett has delivered a formula to us, it makes things easier. But as I’ve said before, easy does not mean simple. The x-factor remains to be the investor. Any fool can follow a formula, but not every fool will arrive at the same results! Buffett will have some sage advice for investors themselves in our next installment! Stay tuned!

Related Posts:

• Buffett’s Tenets - On Contrary Thoughts
• Buffett’s Tenets - On Selecting Businesses (Part 1)
• Buffett’s Tenets - On The Market
• Buffett’s Tenets - On Being An Investor