Editor’s note: This article was first published in March 2018. Its statement that Buffett “doesn’t invest in technology companies” was already out of date in 2018: Berkshire Hathaway began buying Apple in 2016 and it had become one of its largest holdings by early 2018.
Let’s summarise the hardest part of the investment analysis Buffett carries out before investing in a company, and try to explain it in a way everyone can understand perfectly. This legendary investor starts from the principles of value investing, which he in a sense inherited from his teacher Benjamin Graham and later refined or adapted, and the fundamental analysis Buffett applies to companies goes even beyond the fundamentals. According to him, how should we analyse the shares of a listed company? Let’s get to it.
How do you analyse a stock to know whether investing in the company is a good idea?
1. The company must be at least 10 years old
This is the first condition Warren Buffett sets for a company before looking at anything else. Buffett doesn’t consider companies that are less than 10 years old, because he believes you can’t make an intelligent investment in a newly created company, which may turn out to be very profitable or may not. Nobody can know, and that is when the investment depends to some extent on luck.
That is why he doesn’t invest in technology companies, besides the fact that he doesn’t understand that kind of business and can’t picture where they will be in the future. With his star stock, Coca-Cola, on the other hand, he knows that if it has survived several severe recessions over more than 100 years, it is almost certain to still be there in another 100 years.
(Read: Warren Buffett’s 16 best pieces of investment advice)
2. A simple business model
Although Buffett doesn’t rule out investing in innovative companies with complex business models, what he really likes are simpler companies. Businesses where anyone can see how they make money are the starting point of the analysis for a long-term investor.
You should be able to explain in 30 seconds what the company you invest in does, so that everyone in a room, whatever their level of education, understands where its profits come from. For example, Ford makes and sells cars. I think everyone understands where Ford’s profits come from.
3. Differentiation, also known as the “economic moat”
The company must offer something different from its competitors and have a product that is clearly distinguishable from the competition. Buffett says these are the companies with a future. And if the company’s product is very hard for competitors to replicate, that is what is called an economic moat, and it is what Warren Buffett loves, because the wider the moat, the harder it is for a competitor to get in. Many have tried to imitate Coca-Cola.
The closest is Pepsi, and if Pepsi still hasn’t managed it, a new company is unlikely to. Can we say the same about smartphone makers?
4. He analyses ROE and compares it with competitors
ROE (return on equity) is the ratio between a company’s profit and the resources needed to generate it:
ROE = net profit after tax / shareholders’ equity
Buffett studies ROE to gauge the operating capacity of the company in question by analysing it and comparing it with other companies in the same industry (its competitors).
But he warns that return on equity over a couple of years is not enough to get a complete picture of the company. For this analysis to be effective, you need to look at a minimum of 5 to 10 years of the company’s operations.
(Read: 10 Warren Buffett quotes for business)
5. Consistent profit margins
For Buffett, there is no successful company unless it shows coherence and consistency in its profit margins.
The profit margin is calculated by dividing total earnings by net sales. Look at a chart of the last 5 or 10 years. If you find an upward trend (rising profit margins), you are looking at a well-managed company.
Of course, if profit margins are flat but very wide, and have been for the last five years, you are also looking at effective management, since all you need to wait for is for the company to sell more in order to earn more.
6. The hardest part: spotting an undervalued company
This is the part that has probably made investors such as Buffett and Graham unique. Buffett is an expert in this kind of analysis.
Before investing in a company, an investor should assess its intrinsic value. To do so, the investor must take into account the company’s earnings, revenue and assets. As a general rule, a company’s intrinsic value is higher than its liquidation value.
Buffett compares that value with the company’s current market capitalisation. He says that if the intrinsic value you have worked out is 25% higher than the company’s market capitalisation, it is an excellent investment opportunity, because the market will eventually give the company the value it deserves.
We have to say that these days you will rarely find a company that meets this Warren Buffett requirement (if anyone finds one, please let us know!).
7. Growing earnings
Warren Buffett likes companies that have had, and still have, the ability to grow earnings consistently and create value for shareholders. To check this, we again need to analyse the company’s track record since it was founded.
But Buffett warns that even excellent past performance doesn’t guarantee similar performance in the future, although the company’s historical performance helps us predict its future by showing a trend. If a company’s sales and earnings have trended upwards for 50 years, it will most likely continue that trend.
8. Companies with very little debt
As a businessman and investor, Buffett is very clear that debt is the cancer of both personal and corporate finances. That is why he looks for companies with little debt that, ideally, grow mostly with their own funds rather than borrowed money.
In the same way, he analyses the debt-to-equity ratio, or in other words, total liabilities divided by the company’s assets. The higher the number, the higher the debt ratio, and therefore the more volatile the earnings, since more debt means more interest expense.
Watch out for companies that make no profit and refinance their debts over the long term in the hope that profits will grow. Part of the profits they were hoping for, if they ever arrive, will go to paying off the debt and the interest it generates.
9. A good manager
Most investors don’t take a company’s CEO into account and forget to analyse them the same way we analyse the company we are going to invest in. We should also consider a new CEO’s track record: where they come from, what they have achieved, how they think, what contacts they have and so on.
Still, Buffett himself often says something along these lines: invest in companies with a product so easy to sell that even an idiot could run them, because sooner or later an idiot will.
10. Heavy R&D spending is not a plus for Buffett
While most managers praise spending on research and development, since it keeps a company constantly discovering things and making future improvements, Buffett prefers to invest in companies that don’t devote much of their budget to R&D.
According to Buffett, companies that spend large amounts on R&D tend to be companies where technology and innovation are key to how they work and to their future. And that view clashes with several of the points above, where the business should be simple and the company should already have a clear advantage over its competitors.
Recommended: 8 life lessons from Warren Buffett (beyond investing and business)
Featured image: Ktkvtsh, CC0 1.0, via Wikimedia Commons.
