|Warren Buffett: How he does it
By The Investing Guys, Investopedia.com
you know that a $10,000 investment in Berkshire
Hathaway in 1965, when Buffett took control of it, would have
a worth of over $50 million in 2003? In comparison, $10,000 in the
S&P 500 would have grown to
only $500,000. Whether you like him or not, Buffett's investment
strategy, known as value investing,
has been one of the most successful ever. Here we look at how Buffett
amassed this fortune solely from investing.
is the Buffett Investing Philosophy?
Value investing looks for stocks whose prices are low for their
companies' supposed intrinsic worth, which is determined by an analysis
of certain characteristics and fundamentals
of companies. Mirroring the mentality and shopping style of a bargain
hunter, value investors looks for products that are beneficial and
high quality but cheap in price. In other words, the value investor
searches for stocks that he or she believes are undervalued
by the market. Like the bargain hunter, the value investor tries
to find those items that are valuable but not quite recognized as
such by the majority of other buyers.
Warren Buffett takes this value investing approach to another level.
Many value investors aren't supporters of the Efficient
Market Hypothesis but trust that the market will eventually
properly start to favor those quality stocks that were, for a time,
undervalued. Buffett, however, doesn't think in these terms. He
isn't concerned with the supply and demand intricacies of the stock
market. In fact, he is not really concerned with the activities
of the stock market at all. He chooses stocks solely on the basis
of their overall potential as companies--he looks at each company
as a whole. Holding these stocks for the extended long term, Warren
Buffett seeks not capital gain
but ownership in quality companies that are highly capable
of generating earnings. When Warren Buffett invests in a company,
he is not concerned whether the market will eventually recognize
the company's worth; he is concerned with how well that company
can make money as a business.
How Does Buffett Find Low-Priced Value?
Here we look at some of the questions that Buffett asks himself
when he evaluates the relationship between a stock's level of excellence
and its price. Keep in mind that these are not the only things that
Has the company consistently performed well?
Sometimes ROE is referred to as "stockholder's return on
investment." It tells the rate at which shareholders are
earning income on their shares. Warren Buffet always looks at
the return on equity (ROE)
to see whether or not a company has consistently performed well
in comparison to other companies within the same industry. ROE
is calculated as follows:
Just having a high ROE last year isn't enough. The investor
should view the ROE from the past five to ten years to get a
good idea of the historical growth.
2. Has the company avoided excess debt?
The debt/equity ratio
is another key characteristic that Warren Buffett carefully
considers. Buffett prefers to see a very small amount of debt,
which means earnings growth is being generated from shareholders'
equity. The debt/equity ratio is calculated as follows:
This ratio indicates the proportion of equity and debt the
company is using to finance its assets, and the higher the
ratio, the more debt--rather than equity--is financing the
company. A high level of debt compared to equity can result
in volatile earnings and large interest expenses. For
a more stringent test, investors sometimes use only long-term
debt instead of total liabilities.
3. Are profit margins high? Are they increasing?
The profitability of a company depends not only on having
a good profit margin
but also on consistently increasing this profit margin. This
margin is calculated by dividing net income by net sales.
To get a good indication of historical profit margins, investors
should look back at least five years. A high profit margin
indicates that the company is executing its business well,
but increasing margins means that management has been extremely
efficient and successful at controlling expenses.
4. How long has the company been public?
Buffett typically considers only companies that have been
around for at least ten years. As a result most of the technology
companies that have had their IPOs
in the past decade wouldn't get on Mr. Buffett's radar. It
makes sense that one of Buffet's criteria is longevity: value
investing means looking at companies that have stood the test
of time but are currently undervalued. Never underestimate
the value of historical performance, which demonstrates the
company's ability (or inability) to increase shareholder earnings.
Do keep in mind, however, that the past performance of a stock
does not guarantee future performance--the job of the value
investor is to determine how well we can trust that the company
has a capacity to perform as well as it did in the past.
5. Do the company's products rely on a commodity?
Initially you might think of this as a radical approach to
narrowing down a company, but Buffett tends to shy away (but
not always) from companies whose products are indistinguishable
from competitors, and those that rely solely on a commodity
such as oil and gas. He does not put his money into companies
that rely on the price of an underlying commodity. If the
company does not offer anything different than another firm
within the same industry, be wary as a value investor.
6. Is the stock selling at a 25 percent discount to its
This is the kicker. Finding companies that meet the other
five criteria is one thing, but determining whether they are
undervalued is the key for value investing, and finding a
company that is trading at a 25 percent discount is not always
easy. To check this, we must determine the intrinsic
value of a company by analyzing a number of business fundamentals,
including earnings, revenues, and assets. A company's intrinsic
value is usually higher than its liquidation
value, which is what a company would be worth if it were broken
up and sold today--the liquidation value doesn't include intangibles
such as the value of a brand name, which is not directly stated
on the financial statements.
Buffett determines this intrinsic value of the company as
a whole, he compares it to its current market
capitalization, which is the current total worth (price)
of the entire company. If his measurement of intrinsic value
is at least 25 percent higher than the company's market capitalization,
Warren Buffet sees the company as one that has value. Sounds
easy, doesn't it? Well, Buffett's success, however, depends
on his unmatched skill in accurately determining this intrinsic
value. While we can outline some of his criteria, we certainly
have no way of knowing exactly how he gained such precise
mastery over calculating value.
Well, as you have probably noticed, Warren Buffett's investing style,
like the shopping style of the bargain hunter, reflects a practical,
down-to-earth attitude. This attitude Buffett maintains toward also
his lifestyle and overall philosophy on life: he doesn't live in a
huge house, he doesn't collect cars, and he doesn't take a limousine
to work. The value-investing style is not without its critics, but
whether you support Buffett or not, the proof is in the pudding. As
of 2003, he holds the title of the second richest man in the world,
with a net worth of over $30 billion (Forbes 2003). If you
choose to practice this kind of investing style, keep in mind that
it takes time to do the proper analysis and to get good at it.
With thanks to
Check out www.investopedia.comInvestopedia for more great articles.