****Buffett Fundamental Investing: How to pick stocks like Warren Buffett

Buffett Fundamental Investing

How to Pick Stock Like Warren Buffett by Timothy Vick

1.  Intrinsic Value = sum total of future expected Earnings with each year's Earnings discounted by the Time Value of Money.

2.  A company's Growth record is the most reliable predictor of its future course.  It is best to average past Earnings to get a realistic figure.  Each year's Earnings need to be discounted by the appropriate discount rate.

3.  Is the stock more attractive than a bond?  Divide the 12 months EPS by the current rate of long-term Government Bonds e.g. EPS of $2.50 / 6% or 0.06 = $40.  If the stock trades for less than $40, it is better value than a bond.  If the share's earnings are expected to grow annually, it will beat a bond.

4.  Identify the expected Price Range, Projected future EPS 10 years out, based on average of past EPS Growth.  Multiply by the High and Low PE Ratios to find the expected Price Range.  Add in the expected Dividends for the period.  Compute an annualised Rate of Return based on the increase in the Share Price.  Buffett's hurdle is 15%.

5.  Book Value.  Ultimately, Price shoud approximate growth in Book Value and in Intrinsic Value.  Watch out the increases in Book Value which are generated artificially

• a) issuing more shares
• b) acquisitions
• c) leaving cash in the bank to earn interest, in which case ROE will slowly fall. 

Buffett is against the use of accounting charges and write-offs to artificially improve the look of future profits.

6.  Return on Equity.  ROE = Net Income (end-of-year Shareholders' Equity + start-of-year Shareholder's Equity/2).  Good returns on ROE should benefit the Share Price.  High ROE - EPS Growth - Increase in Shareholder's Equity - Intrinsic Value - Share Price.  A high ROE is difficult to maintain, as the company gets bigger.  Look for high ROE with little or no debt.  Drug and Consumer product companies can carry over 50% Debt and still have high ROEs.  Share buy-backs can be used to manipulate higher ROEs.  ROE should be 15%+.

7.  Rate of Returns.  15% Rule.  Collect and calculate figures on the following:

• current EPS
• estimate future Growth Rate of use Consensus Forecasts
• calculate historic average PE Ratio
• calculate Dividend Payout Ratio

-----
Tabulation in Table Format

Price:
EPS:
PE:
Growth Rate:
Average PE:
Dividend Payout:

Year ---- EPS
20-
20-
20-
20-
20-
20-
20-
20-
20-
20-
----------------
Total

Price needed in 10 years to get 15%:  $____

Expected 10-year Price (20--EPS* Av. PE):  $____
Plus expected Dividends:  $____

Total Return:  $____

Expected 10-year Rate of Return:   ____%

-----
Highest Price you can pay to get 15% return: $ _____

------



Stock Evaluation.  Can a company earn its present Market Cap.  in terms of future Profits?  Does the company have a consistent record of accomplishment?

Shares are Bonds with less predictable Coupons.  Shares must beat inflation, Government Bond Yields and be able to rise over time.  Shares should be bought in preference to Bonds when the current Earnings Yield (Current Earnings/Price) is at or above the level of long-term Bonds.

When To Sell:

• Bond Yields are rising and about to overtake Share Earnings Yields.
• Share Prices are rising at a greater rate than the economy is expanding.
• Excessive PE multiples, even allowing for productivity and low interest rates.
• Economy cannot get any stronger.

Takeover Arbitrage

• Buy at a Price below the target takeover Price.
• Only invest in deals already announced.
• Calculate Profits in Advance.  Annualised return of 20-30% needed.
• Ensure the deal is almost certain.  A widening spread may mean the worst.

General Criteria:

• Consistent Earnings Growth
• High Cash Flow and Low level of Spending
• Little need of long-term Debt
• High ROE 15%+
• High ROA (Return on Total Inventory plus Plant)
• Low Price relative to Valuation.

Buffett-Style Value Criteria and Filter.

1.  Earnings yield should be at least twice the AAA bond yield (which is about 5.9%)
2.  PE should be less than 40% of the share's highest PER over the previous five years.
3.  Dividend yield should be at least two thirds of the AAA bond yield.
4.  Stock price should be no more than two thirds of company's tangible book value per share.
5.  Company should be selling in the market for no more than two thirds of its net current assets.

To this, add Margin of Safety criteria:

1.  Company should owe no more than it is worth:  total debt should not exceed book value.
2.  Current assets should be at least twice current liabilities - in other words, the current ratio should exceed 2.
3.  Total debt should be less than twice net current assets.
4.  Earnings growth should be at least 7% a year compound over the past decade.
5.  As an indication of stability of earnings, there should have been no more than two annual earnings declines of 5% or more during the past decade.


Demanding a share price no more than two-thirds tangible assets is asking too much of today's market.  The basic search, therefore, used the following sieves:

1.  PE less than 8.5.  This is the implied multiple from the demand that the earnings yield should be more than twice 5.9%.  The inverse of an 11.8% earnings yield is a price-earnings multiple of 8.5.
2.  A dividend yield of at least 4% - two thirds of the 5.9% AAA bond yield.
3.  A Price to Tangible Assets Ratio of less than 0.8 - price less than four-fifths tangible assets.
4.  Gross Gearing of less than 100% -  the company does not owe more than it is worth.
5.  Current Ratio of at least two - in other words current assets are at least twice current liabilities.


http://www.docstoc.com/docs/7984050/Investment-Strategies (Page 91)