Greetings all! Today I’ve finally found some free time to put together a more thorough posting. (Yes, even in the middle of finals week!) I have been interested in evaluating a list of companies from different sectors of the economy using Warren Buffet’s methodology and my personal methodology. Note, these are just a few of the criteria Warren and I will use to evaluate a company for investment; this is by no means an exhaustive list, nor should stocks be bought based solely on these recommendations. Always do your own due diligence. What follows is a list of what Warren Buffett uses to evaluate companies:
1. Has the company consistently performed well?
Sometimes return on equity (ROE) is referred to as "stockholder's return on investment". It reveals the rate at which shareholders are earning income on their shares. Buffett always looks at ROE to see whether or not a company has consistently performed well in comparison to other companies in the same industry. ROE is calculated as follows:
Sometimes return on equity (ROE) is referred to as "stockholder's return on investment". It reveals the rate at which shareholders are earning income on their shares. Buffett always looks at ROE to see whether or not a company has consistently performed well in comparison to other companies in the same industry. ROE is calculated as follows:
Should look at ROE from last 5 to 10 years to get a good idea of historical performance.
2. Has the company avoided excess debt? The debt/equity ratio is another key characteristic Buffett considers carefully. Buffett prefers to see a small amount of debt so that earnings growth is being generated from shareholders' equity as opposed to borrowed money. The debt/equity ratio is calculated as follows:
| = Total Liabilities / Shareholders' Equity |
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 the company is executing its business well, but increasing margins means management has been extremely efficient and successful at controlling expenses.
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 the company is executing its business well, but increasing margins means 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 10 years.
Buffett typically considers only companies that have been around for at least 10 years.
5. Do the company's products rely on a commodity?
Initially you might think of this question as a radical approach to narrowing down a company. Buffett, however, sees this question as an important one. He tends to shy away (but not always) from companies whose products are indistinguishable from those of competitors, and those that rely solely on a commodity such as oil and gas.
6. Is the stock selling at a 25% discount to its real value?
In order to find real value, it is advised to use a DCF (Discounted Cash Flow) analysis.
(Source: Investopedia)
Basically, Warren Buffett wants to find a company that has been around a while and has a solid history of performance. He wants that company to have a durable competitive advantage, and most importantly wants to purchase it for below its real or “intrinsic” value.
Warren Buffett is a genius and there is no disputing that. Nowadays he is even a bit of a self-fulfilling prophecy. That is, if he buys a stock, the stock will usually increase in value just because he, Warren Buffett, has bought it. (Although this hasn’t held true as of late for his investment in Bank of America.)
I am aspiring to be an investor of Warren Buffett’s genius, but we will see if this comes to fruition later in my life. For now, I must start where I can, with research, reading, and dabbling in the market. My basic investing philosophy is: invest in companies that are either selling at or below market value with a solid business model and good products, or purchase riskier, higher growth potential stocks whose prospects are bright. I can afford the latter strategy because of my youth. After all, how can you really make a killing if you don’t take risk every now and then? Underpinning every investment I make is an analysis of the greater macroeconomic trend and fundamental analysis to make sure the company is sound. I also enjoy timing investments using technical analysis. (This is used more often in short-term investments.)
So what do I look at?
1.PEG ratio of 1 or less. Price to earnings to growth ratio is what PEG is. That is, I want to purchase a company only if its P/E ratio is equal to or less than its growth rate. This ensures you are paying a fair price for a company.
2.Little or no debt. Like Buffett, I want to see that the company I am invested in generates most of its revenue from equity and not borrowed cash. In my research, I have observed that companies that perform incredibly well over the long term have very little or no debt.
3.Forward P/E- This is just one indicator that would let me know if I can purchase a company at a price now that is a discount from where it will be trading in the next year. Ex.- Apple trades at a P/E of 13.5. It’s forward P/E is 9.6. Theoretically, I can purchase the company at a lower price now than it will be trading at in the future.
4.Industry comparables- I want to make sure that the company I am invested in is not superficially over valued compared to its competitors. Many factors can play into this, however, such as brand identification, loyalty, trust, a better product, etc.
5.Quick Ratio- This can give me a snap shot of the financial health and efficiency of a corporation. Comon, I am a time strapped college student, and sometimes I need something quick and easy! (not advisable to invest this way)
6.Is the product unique?
I want to make sure that the company either has a unique product, which sets it apart from its competitors and gives it an advantage, or I want to know that many people will use the product for years to come. The reason I add the last part is, for example, I am not against investing in oil and gas companies. These products may not be unique, but they are used by many and will be for quite some time.
7.Do I like the company?
-As a young man very immersed in the world and knowledgeable about consumer culture, I believe that I possess a good idea about what makes a company good and whether or not it will be successful. As an example, I could have told you to buy Google or Chipotle stock when they first came public. I used Google as a 4th grader before it was public, and while my librarian was telling me to use Askjeeves.com. I understood that Google had a better product, was a better company, and would beat out askjeeves. The same is true for Chipotle. I recognize their uniqueness, the intelligence of management, and their prospects for growth. This is more of a gut feeling, I guess you could say. Follow your gut on investments. I once purchased a company called Motricity, because Jim Cramer recommended it as a possible acquisition target for a larger company. The service they provide is to offer internet connectivity to non smart phones. I knew right away this was going to be a dead business in a few years, as smart phones were the future. I invested anyway, because I thought Jim Cramer knew what he was talking about. I bought it at 20, sold at 17 (cut my losses), and it is now trading at 1.36 (phew). I do not regret the experience, as I now know to forever trust my gut when investing.
8.Technical analysis
-Like Warren Buffett, technical analysis is a bit of a self-fulfilling prophecy as well. It really only works because people think it will work and then they trade off of that, further making it work. All moves in the market, after all the fog clears, will be made by corporate earnings and macroeconomic conditions. Technical analysis does work and can be used to time trades if you have a shorter term investing horizon.
-Like Warren Buffett, technical analysis is a bit of a self-fulfilling prophecy as well. It really only works because people think it will work and then they trade off of that, further making it work. All moves in the market, after all the fog clears, will be made by corporate earnings and macroeconomic conditions. Technical analysis does work and can be used to time trades if you have a shorter term investing horizon.
9.I also like to check stock ratings in Investor’s Business Daily and ratings done by research analysts. These people are paid to research companies and recommend investments. Take everything with a grain of salt, but it is helpful to get their opinion on the companies you want to invest in.
So, now that I’ve outlined the criteria for analyzing companies, we must choose a list of stocks we would like to investigate. From this list, I want to compile a virtual stock portfolio to manage, so I am going to choose companies across different sectors of the economy. Lets choose energy, food, retail, technology, agriculture, and industrial type companies.
Energy: Chevron, Stone Energy, Chesapeake Energy.
Food: Chipotle, Hain Celestial, Whole Foods
Retail: Lululemon, Deckers Corp., Coach
Technology: Apple, Skyworks Solutions, Arm Holdings
Agriculture: John Deer, Potash, Mosaic
Industrial: Boeing, Caterpillar, General Electric
This is just part 1, stay tuned tomorrow for part 2 which will get into the actual analysis.
Cheers,
EZ
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