Who is Warren Buffett?

Warren Buffett is arguably the greatest investor of all time. He is often dubbed “The Oracle of Omaha” because of his incredible ability to seemingly predict winning stocks. In 2009, Forbes magazine ranked him as the second richest man in America at an estimated net worth of 40 billion dollars. His company, Berkshire Hathaway has been incredibly successful. If you had invested 1,000 dollars in Berkshire Hathaway when he first took it over, your investment would have grown to 3 million dollars 40 years later.

How does he do it?

Warren Buffett follows an investment strategy known as Value Investing, which was created by Benjamin Graham. The Value Investment strategy looks to find undervalued stocks by determining a stock’s “intrinsic value.” This intrinsic value is not easy to determine, there is no formula to discover the intrinsic value of a company. Value investing is a lot like bargain hunting. A value investor tries to find companies that have been undervalued by the market, by determining that the true value of a company is higher than it is being sold for.

Buffett believes that when purchasing stock, one should view it as purchasing a piece of a company. You are buying the business. He is quoted saying “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” After he finds his great company he holds on to it for a very long time, for instance, he bought stock in American Express during the 1960s and has held on to it ever since.

Buffett’s Method

You can categorize the aspects that Buffett investigates into two categories, Quantitative and Qualitative. Quantitative looks into the financials of the company; is the business a good business? Qualitative looks into the competitive advantages one company might have over others.

The Financials

1) Profit Margin. Formula = Net Income/ Total Sales

What is the profit margin of the company? This is calculated by dividing a company’s net income by it’s total sales. This looks at how much money is earned as profit relative to how much money is generated on sales, how many cents on each dollar sold does the company keep. It is important that a companies profit margin is constantly growing. Compare this year’s profit margin and the last couple years. If the profit margin is high and is growing then, the company has a good profit margin.

2) Debt. How much debt does the company have? Formula =Total Liabilities/ Total Asset and Total Liabilities/ Shareholder’s Equity

The total debt ration can be found by dividing a companies liabilities by it’s assets. If you compare several years debt ratio, a shrinking ration indicates increasing amounts of total assets while reducing the total amount of debt. If it is increasing then the company is taking on more debt while obtaining less assets.

The debt/equity ratio calculated by dividing liabilities by total assets is also important. This calculates how much equity and debt is being used to fund the company’s assets. If the number is large, it indicates that the company funding their assets with more debt than equity which can lead to unsustainable earnings.

3) Company Performance. Formula = Net Income/ Shareholder’s Equity

Buffett always looks at a company’s Return On Equity, also known as ROE. ROE is calculated by dividing a company’s Net Income by its Shareholder’s Equity (Net Income/ Shareholder’s Equity). It is important to look at the historical performance of the company, not just the most recent ROE but rather, the past five to ten years. A percentage of 15% and higher is usually a good indicator.

Competitive Advantage

1) Does this company rely on a commodity? Or does it sell a superior product?

Does the company sell a product that has little difference between competition (for example, gasoline)? Although, this does not always disqualify a company for Warren Buffett, he usually does not invest in this type of company. Conversely if a company has a product that is simply better than all the competitor’s, it is a good choice. For example, if you think about Reebok and Nike, clearly Nike is the more popular shoe company. Also Google surpassed Yahoo as the most popular search engine because it’s easier to use and you get better results.

2) Brand Name

Does the company have a trusted and well known brand name? At grocery stores, generic tissue paper is placed right next to Kleenex tissues and more people buy Kleenex despite the fact it is more expensive. Why, because it has an extremely successful brand name.

3) Monopolies

Legal Monopolies – In several cases, the government allows certain companies to have a legal monopoly where they are the only uncontested business in a certain category. This happens most often in Utilities. A west coast example of this is Pacific Gas and Electric company (PGNE) which is a government granted monopoly.

Start Up Costs – Some companies cost so much money to start up that no other company will try to contest it.

An example would be the semi-conductor business because it requires a lot of tech smart people and a lot of expensive machinery.

4) High Switching Costs

In some cases, when a company has many consumers it may be expensive for them to switch to a competitor. This does not always have to do with money, though. Windows, for example, has a strong hold on the computer industry. Despite the wide-spread dislike of Windows Vista, most consumers stuck with Windows and did not switch to Apple or Linux because they had such a high amount of loyalty and familiarity with the Windows system.

5) Size Advantage

Some companies are so much larger than their competitors that they can use their size obtain maintenance costs. For instance, Wal-Mart is able to sell their products for lower prices then Target.

6) Only Invest in a company that you understand

Buffett firmly believed that he would not invest in a company that he did not understand. Therefore, he never invested in a technological stock because he didn’t understand what exactly the company did. He also tends to invest in companies that have been publicly traded for over ten years. This allows you to determined if a company can perform well compared to its past performance. This is not an easy thing to do but, Buffett was very good at it.

Picking the stock

Buffett will use all this information to help him determine a stock’s intrinsic value. The intrinsic value is the true price of a company. This is then compared to the market cap of the stock he is interested in. The market cap is the current market’s value of a company. If the intrinsic value of the company is 25% lower than the market cap, then it is a stock worth buying. It sounds relatively simple, Buffett’s method is fairly easy to understand and uses a lot of common sense. It is much easier said than done though, if you can really get a handle on determining the intrinsic value of a company accurately, you are well on your way to being a very successful investor.