Buffett: His investment performance, widely documented, has been consistently superior.

Program trading, leveraged buyouts, junk bonds, derivative securities, and index futures have frightened many investors.  The grind of fundamental research has been replaced by the whirl of computers.

Throughout the last few decades, investors have flirted with many different investment approaches.  Periodically, small capitalization, large capitalization, growth, value, momentum, thematic and sector rotation have proven financially rewarding.  At other times, these approaches have stranded their followers in periods of mediocrity.

Buffet, the exception, has not suffered period of mediocrity.  His investment performance, widely documented, has been consistently superior.  As investors and speculators alike have been distracted by esoteric approaches to investing, Buffett has quietly amassed a multi-million-dollar fortune.  Throughout, businesses have been his tools, common sense his philosophy.

Ultimately, the best investment ideas will come from doing your own homework. You should not feel intimidated.

Investment success is not synonymous with infallibility.  Rather, it comes about by doing more things right than wrong.

The success in your investment approach is as much a result of eliminating those things you can get wrong, which are many and perplexing (predicting markets, economies, and stock prices), as requiring you to get things right, which are few and simple (valuing a business).

When purchasing stocks, you should focus on two simple variables:  the price of the business and its value.  The price of the business can be found by looking up its quote.  Determining value requires some calculation, but it is not beyond the ability of those willing to do some homework.

The wonderful thing is because you are no longer worry about the stock market, the economy, or predicting stock prices, you are now free to spend more time understanding your businesses.

More productive time can be spent reading annual reports and business and industry articles that will improve your knowledge as an owner.  The degree to which you are willing to investigate your own business lessens your dependency on  others who make a living advising people to take irrational action.

Ultimately, the best investment ideas will come from doing your own homework.  You should not feel intimidated.

Determining how to allocate your savings is the most important decision you, as an investor, will make.

The "Good Investment". Clarify your Investment Goals.

By pinpointing what you think represents value, you can now create your definition of a good investment.   You should be able to summarize it in one sentence.

Consider these examples:

Warren Buffett:  a good business that can be purchased for less than the discounted value of its future earnings.

George Soros:  an investment that can be purchased (or sold) prior to a reflexive shift in market psychology/fundamentals that will change its perceived value substantially.

Benjamin Graham:  a company that can be purchased for substantially less than its intrinsic value.

A few more examples:

The Corporate Raider:  companies whose parts are worth more than the whole.

The Technical Analyst:  an investment where technical indicators have identified a change in the price trend.

The Real Estate Fixer-Upper:  run-down properties that can be sold for much more than the investment required to purchase and renovate them.

The Arbitrageur:  an asset that can be bough low in one market and sold simultaneously in another at a higher price.

The Crisis Investor:  assets that can be bought at fire-sale prices after some panic has hammered a market down.


Coming to your definition of a good investment is easy - if you're clear about the kinds of investments that interest you and have clarified your beliefs about prices and values.

Your mental focus is: on YOUR INVESTMENT PROCESS

The Master Investor treats investing like a business: he doesn't focus on any single investment but on the overall outcome of the continual application of the same investment system over and over and over again.  He establishes procedures and systems so that he can compound his returns on a long-term basis.  And that's where his mental focus is:  on his investment process.  

Once you're clear what kind of investments you'll be buying, what your specific criteria are, and how you'll minimize risk, you need to establish the rules and procedures you'll follow to gain the Master Investor's long-term focus.


Bottom line:  Focus on your investment process  to compound your returns on a long-term basis

BUFFETT’S EQUITY BOND.

BUFFETT’S COMPANY ANALYSIS TEMPLATE.

Below is a Summary of what Warren Buffett targets in a company’s three Financial Statements and his use of his Equity Bond Theory in order to evaluate a company and to determine a preferable purchase price.

In my opinion, one could regard all these requirements as a form of COMPANY ANALYSIS TEMPLATE with which an Industrial type company should comply in order to satisfy Buffett’s Investment Criteria, which should, in turn, lead to a profitable long-term investment.

_______________________________________________________________

INCOME STATEMENT.

GROSS PROFIT :- Gross Profit = Cost of Sales/Revenue >40%

SG&A EXPENSES :- SG&A < 30% x Gross Profit

R&D EXPENSES :- Little or Nil

DEPRECIATION :- Depreciation < 10% x Gross Profit

INTEREST EXPENSE :- Interest Expense < 15% x Operating Income (i.e. EBIT)

PRETAX INCOME :- VERY IMPORTANT NUMBER, especially for previous 12 months

NET EARNINGS :- Net Earnings > 20% x Total Revenue

EARNINGS PER SHARE :- 10 Year Trend showing Consistency & Upward Trend

_______________________________________________________________

BALANCE SHEET.

ASSETS.

CASH & SHORT TERM INVESTMENTS :- Ongoing increase from Business Operations NOT from One-Time events

INVENTORY :- Corresponding Rise in both Inventory & Net Earnings

CURRENT RATIO :- Current Assets/Current Liabilities < 1, due to Strong Earning Power

PROPERTY, PLANT & EQUIPMENT :- Low as possible

LONG TERM INVESTMENTS :- Large as possible. Should be Quality Investments, preferably in other DCA companies

RETURN ON ASSETS (ROA) :- High BUT with Large Total Assets to reduce Vulnerability

LIABILITIES.

SHORT TERM DEBT :- Avoid bigger borrowers of Short Term money rather than Long term money

LONG TERM DEBT DUE :- Little or Nil

LONG TERM DEBT :- Long Term Debt < 3 x Annual Net Earnings

DEBT/SHAREHOLDER’S EQUITY :- Debt/S.H.Equity < 0.8 where S.H.Equity INCLUDES Value of Treasury Stock

PREFERRED STOCK :- Nil

RETAINED EARNINGS :- Annual Increase > 7%

TREASURY STOCK :- Should appear and be regularly purchased

RETURN ON SHAREHOLDER’S EQUITY (ROE) :- Net Income/S.H.Equity > 25%

_______________________________________________________________

CASH FLOW STATEMENT.

INVESTING OPERATIONS :- Based on +/-10 Year Period, Capital Expenditure/Net Earnings < 50%

For DCA company this ratio is consistently < 25%.

FINANCING ACTIVITIES :- “Issuance (Retirement) of Stock, Net” to be a regular NEGATIVE Value.

This indicates a NET Buying Back of its own Shares compared to a NET Issuance of its Shares.

_______________________________________________________________

BUFFET’S EQUITY BOND.

THE THEORY. 

Companies with DURABLE COMPETITIVE ADVANTAGE (DCA) can be seen as an EQUITY BOND with a COUPON.

Equity Bond = Share Price
Bond Coupon = Pretax Earnings/Share

DETERMINE SHARE PRICE. 

Stock Market will price a DCA company’s Equity Bond at a level that approximately reflects the Value of its Earnings RELATIVE to the Yield on LONG TERM CORPORATE BONDS (LTCB)

Equity Bond = Share Price = Coupon Rate/Long Term Corporate Bond Rate (LTCBR)
Coupon Rate/LTCBR = Pretax Earnings/LTCBR

WHEN TO BUY. 

(1) Buy during Bear Markets or when share prices are depressed due to no fault of the company

(2) Buy when Share Price < Pretax Earnings per Share/LTCBR by a reasonable discount

WHEN TO SELL.

(1) Sell when presented with a BETTER company at a BETTER Price

(2) Sell when a current DCA company is losing its Durable Competitive Advantage

(3) Sell during Bull Markets or when prices are at unrealistically HIGH levels

(4) Sell when P/E ratios > 40+, especially if the stock’s price far EXCEEDS THE LONG-TERM ECONOMIC REALITIES OF THE BUSINESS


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Valuing Stocks the Warren Buffett Way

The Warren Buffett approach to investing makes use of “folly and discipline”: the discipline of the investor to identify excellent businesses and wait for the folly of the market to drive down the value of these businesses to attractive levels.


Most investors have little trouble understanding Buffett’s philosophy. The approach encompasses many widely held investment principles. However, its successful implementation is dependent upon the dedication of the investor to learn and follow the principles.




Like most successful stockpickers, Warren Buffett thinks that the efficient market theory is absolute rubbish. Buffett has backed up his beliefs with a successful track record through Berkshire Hathaway, his publicly traded holding company.

Unfortunately, Buffett has never expounded extensively on his investment approach, although you can glean tidbits from his writings in the Berkshire Hathaway annual reports. However, a cottage industry has sprung up over the years as outsiders have attempted to explain Buffett’s investment philosophy. One book that discusses his approach in an interesting and methodical fashion is “Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett the World’s Most Famous Investor” (Scribner, 1999) written by Mary Buffett, a former daughter-in-law of Buffett’s, and David Clark, a family friend and portfolio manager.

This book served as the basis for two stock screens developed and tracked by AAII—Buffettology EPS Growth and Buffettology Sustainable Growth. These screens are also pre-built into AAII’s Stock Investor Pro fundamental stock screening and research database program.

In this article, we provide an overview of Buffettology as a method of identifying promising businesses. In addition, we present a Buffett valuation spreadsheet that uses various valuation models to measure the attractiveness of stocks passing the preliminary screens.

Defining an Attractive Company

Warren Buffett seeks first to identify an excellent business and then to acquire the firm if the price is right. Buffett is a buy-and-hold investor who prefers to hold the stock of a good company earning 15% year after year over jumping from investment to investment with the hope of higher, short-term gains. Once he identifies a good company and purchases it at an attractive price, Buffett holds the stock for the long term until the business loses its attractiveness or a more attractive alternative investment presents itself.

Buffett seeks businesses whose product or service will be in constant and growing demand. In his view, businesses can be divided into two basic types:

• Commodity-based firms—selling products where price is the single most important factor determining purchase. They are characterized by high levels of competition in which the low-cost producer wins because of the freedom to establish prices. Management is vital for the long-term success of these types of firms.
• Consumer monopolies—selling products where there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product or service unique.

While Buffett is considered a value investor, he passes up the stocks of commodity-based firms even if he can purchase them at a price below the intrinsic value of the firm. An enterprise with poor inherent economics often remains that way. The stock of a mediocre business generally only treads water.

How do you spot a commodity-based company? Buffett watches out for these characteristics:

• Low profit margins (net income divided by sales);
• Low return on equity (earnings per share divided by book value per share);
• Absence of any brand-name loyalty for its products;
• The presence of multiple producers;
• The existence of substantial excess capacity;
• Profits tend to be erratic; and
• Profitability depends upon management’s ability to optimize the use of tangible assets.

Buffett instead seeks out consumer monopolies—companies that have managed to create a product or service that is somehow unique and difficult for competitors to reproduce due to brand-name loyalty, a particular niche that only a limited number of companies can enter, or an unregulated but legal monopoly such as a patent.

Consumer monopolies can be businesses that sell products or services. Buffett recognizes three types of monopolies:

• Businesses that make products that wear out fast or are used up quickly and have brand-name appeal that merchants must carry to attract customers. Apple Inc. is a good example of a firm with a strong brand name in demand by customers. As a result, consumers are willing to pay a premium price for Apple products. Other examples include leading newspapers, drug companies with patents, and popular brand-name restaurants such as McDonald’s.
• “Communications” firms that provide a repetitive service, which manufacturers must use to persuade the public to buy their products. All businesses must advertise their items, and many of the available media face little competition. These used to include worldwide advertising agencies, magazine publishers, newspapers, and telecommunications networks. Today, “new media” outlets such as Google and Yahoo! provide on-line advertising that threatens the traditional business models of print media.
• Businesses that provide repetitive consumer services that people and businesses are in constant need of. Examples include tax preparers, insurance companies, and investment firms.

In her Buffettology book, Mary Buffett suggests going to your local convenience store to identify many of these “must-have” products. These stores typically carry a very limited line of must-have products such as Marlboro cigarettes and Wrigley’s gum. However, with the guidance of the factors used to identify attractive companies, we established two basic screens to identify potential investments worthy of further analysis.

The Buffettology Screen

The criteria used for our Buffettology screens are summarized in Table 1. AAII’s Stock Investor Pro is used to perform the screens.

Consumer monopolies typically have high profit margins because of their unique niche; however, a simple screen for high margins may highlight weak firms in industries with traditionally high margins, but low turnover levels.

Our first screening filters look for firms with both gross operating margins and net profit margins above the medians for their industry. The operating margin concerns itself with the costs directly associated with the production of the goods and services, while the net profit margin takes all of the company activities and actions into account.

Table 1. Translating the Buffett Style Into Screening

Questions to determine the attractiveness of the business:


Consumer monopoly or commodity?
Buffett seeks out consumer monopolies selling products in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product unique. Investors can seek these companies by identifying the manufacturers of products that seem indispensable. Consumer monopolies typically have high profit margins because of their unique niche; however, simple screens for high margins may simply highlight firms within industries with traditionally high margins. For our screen, we look for companies with operating margins and net profit margins above their industry norms. Additional screens for strong earnings and high return on equity will also help to identify consumer monopolies. Follow-up examinations should include a detailed study of the firm’s position in the industry and how it might change over time.

Do you understand how the business works?
Buffett only invests in industries that he can grasp. While you cannot screen for this factor, you should only further analyze the companies passing all screening criteria that operate in areas you understand.

Is the company conservatively financed?
Buffett seeks out companies with conservative financing. Consumer monopolies tend to have strong cash flows, with little need for long-term debt. We screen for companies with total liabilities relative to total assets that are below the median for their respective industry. Alternative screens might look for low debt to capitalization or low debt to equity.

Are earnings strong and do they show an upward trend?
Buffett looks for companies with strong, consistent, and expanding earnings. We screen for companies with seven-year earnings per share growth greater than 75% of all firms. To help indicate that earnings growth is still strong, we also require that the three-year earnings growth rate be higher than the seven-year growth rate. Buffett seeks out firms with consistent earnings. Follow-up examinations should include careful examination of the year-by-year earnings per share figures. As a simple screen to exclude companies with more volatile earnings, we screen for companies with positive earnings for each of the last seven years and latest 12 months.

Does the company stick with what it knows?
A company should invest capital only in those businesses within its area of expertise. This is a difficult factor to screen for on a quantitative level. Before investing in a company, look at the company’s past pattern of acquisitions and new directions. They should fit within the primary range of operation for the firm.

Has the company been buying back its shares?
Buffett prefers that firms reinvest their earnings within the company, provided that profitable opportunities exist. When companies have excess cash flow, Buffett favors shareholder-enhancing maneuvers such as share buybacks. While we do not screen for this factor, a follow-up examination of a company would reveal if it has a share buyback plan in place.

Have retained earnings been invested well?
Earnings should rise as the level of retained earnings increase from profitable operations. Other screens for strong and consistent earnings and strong return on equity help to the capture this factor.

Is the company’s return on equity above average?
Buffett considers it a positive sign when a company is able to earn above-average returns on equity. Mary Buffett indicates that the average return on equity for the last 30 years is approximately 12%. We created a custom field that calculated the average return on equity over the last seven years. We then filter for companies with average return on equity above 12%.

Is the company free to adjust prices to inflation?
True consumer monopolies are able to adjust prices to inflation without the risk of losing significant unit sales. This factor is best applied through a qualitative examination of the companies and industries passing all the screens.

Does the company need to constantly reinvest in capital?
Retained earnings must first go toward maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better. This factor is best applied through a qualitative examination of the company and its industry. However, a screen for high relative levels of free cash flow may also help to capture this factor.

Understand How It Works

As is common with successful investors, Buffett only invests in companies he can understand. Individuals should try to invest in areas where they possess some specialized knowledge and can more effectively judge a company, its industry, and its competitive environment. While it is difficult to construct a quantitative filter, an investor should be able to identify areas of interest.

The companies typically passing the Buffettology screens represent a diverse group of companies. An investor should only consider analyzing those firms operating in areas that they can clearly grasp.

To see the companies that are currently passing the AAII Buffettology screens, visit the Stock Screens area of AAII.com.

Conservative Financing

Consumer monopolies tend to have strong cash flows, with little need for long-term debt. Buffett does not object to the use of debt for a good purpose—for example, if a company uses debt to finance the purchase of another consumer monopoly. However, he does object if the added debt is used in a way that will produce mediocre results—such as expanding into a commodity line of business.

Appropriate levels of debt vary from industry to industry, so it is best to construct a relative filter against industry norms. We screen out firms that had higher levels of total liabilities to total assets than their industry median. The ratio of total liabilities to total assets is more encompassing than just looking at ratios based upon long-term debt such as the debt-equity ratio.

Strong & Improving Earnings

Buffett invests only in businesses whose future earnings are predictable to a high degree of certainty. Companies with predictable earnings have good business economics and produce cash that can be reinvested or paid out to shareholders. Earnings levels are critical in valuation. As earnings increase, the stock price will eventually reflect this growth.

Buffett looks for strong long-term growth as well as an indication of an upward trend. In her book, Mary Buffett looks at both the 10- and five-year growth rates. Stock Investor Pro offers seven-year growth rates, so for the predefined Buffettology screens we use the seven-year growth rate to filter for long-term growth and the three-year growth rate to filter for intermediate-term growth. The Buffettology screens first require that a company’s seven-year earnings growth rate be higher than that of 75% of the stocks in the overall database.

It is best if the earnings also show an upward trend. Buffett compares the intermediate-term growth rate to the long-term growth rate and looks for expanding earnings. For our next filter, we require that the three-year growth rate in earnings be greater than the seven-year growth rate.

Consumer monopolies should show both strong and consistent earnings. Wild swings in earnings are characteristic of commodity businesses. An examination of year-by-year earnings should be performed as part of the valuation.

Figure 1. Buffett Valuation Worksheet for VCA Antech

VCA Antech (WOOF) passed the Buffettology Sustainable Growth screen as of May 15, 2009, and is used in Figure 1 to illustrate the Buffett Valuation Spreadsheet. The company operates the largest network of animal hospitals and veterinary diagnostic labs in the country. The company’s earnings per share are displayed in the spreadsheet. [While Stock Investor Pro provides seven-year growth rates, which requires eight years of data, the program provides seven years of financial statement data for display purposes. The spreadsheet displays six years of data to calculate the five-year growth rates.] As we can see, VCA’s earnings per share EPS growth has been strong and consistent, with annual increases over each of the last five years (where Year 1 is the most recent year).

A screen requiring an increase in earnings for each of the last seven years would be too stringent and would not be in keeping with the Buffett philosophy. However, a filter requiring positive earnings for each of the last seven years should help to eliminate some of the commodity- based businesses with wild earnings swings.

A Consistent Focus

Companies that stray too far from their base of operation often end up in trouble. Peter Lynch also avoided profitable companies diversifying into other areas. Lynch termed these “diworseifications.” Quaker Oats’ purchase and subsequent sale of Snapple is classic example.

Companies should expand into related areas that offer high return potential. VCA Antech is the leader in the animal diagnostic lab business, servicing more than 14,000 of the 22,000 animal hospitals in the U.S. This segment offers impressive operating margins, which should benefit the company going forward.

Buyback of Shares

Buffett views share repurchases favorably since they cause per share earnings increases for those who don’t sell, resulting in an increase in the stock’s market price. This is a difficult variable to screen, as most data services do not indicate buybacks. You can screen for a decreasing number of outstanding shares, but this factor is best analyzed during the valuation process.

Investing Retained Earnings

A company should retain its earnings if its rate of return on its investment is higher than the investor could earn on his own. Dividends should only be paid if they would be better employed in other companies. If the earnings are properly reinvested in the company, earnings should rise over time and stock price valuation will also rise to reflect the increasing value of the business.

An important factor in the desire to reinvest earnings is that the earnings are not subject to personal income taxes unless they are paid out in the form of dividends.

Buffett examines management’s use of retained earnings, looking for management that has proven it is able to employ retained earnings in the new moneymaking ventures, or for stock buybacks when they offer a greater return.

Good Return on Equity

Buffett seeks companies with above-average return on equity. Mary Buffett indicates that the average return on equity over the last 30 years has been around 12%. During the valuation process, this average should be checked against more current figures to assure that the past is still indicative of the future direction of the company. Our screen looks for average return on equity of 12% or greater over the last seven years.

Inflation Adjustments

Consumer monopolies can typically adjust their prices quickly to inflation without significant reductions in unit sales, since there is little price competition to keep prices in check. This factor is best applied through a qualitative examination of a company during the valuation stage.

Reinvesting Capital

In Buffett’s view, the real value of consumer monopolies is in their intangibles—for instance, brand-name loyalty, regulatory licenses, and patents. They do not have to rely heavily on investments in land, plant, and equipment, and often produce products that are low tech. Therefore, they tend to have large free cash flows (operating cash flow less dividends and capital expenditures) and low debt. Retained earnings must first go toward maintaining current operations at competitive levels. This is a factor that is also best examined at the time of the company valuation although a screen for relative levels of free cash flow might help to confirm a company’s status.

The above basic filters help to indicate whether the company is potentially a consumer monopoly and worthy of further analysis. However, stocks passing the screens are not automatic buys. The next test revolves around the issue of value.

The Price Is Right: Using the Buffett Valuation Spreadsheet

 The price that you pay for a stock determines the rate of return—the higher the initial price, the lower the overall return.  Likewise, the lower the initial price paid, the higher the return. Buffett first picks the business, and then lets the price of the company determine whether to purchase the firm. The goal is to buy an excellent company at a price that makes business sense. Valuation equates a company’s stock price to a relative benchmark. A $200 dollar per share stock may be cheap, while a $2 per share stock may be expensive.

Buffett uses a number of different methods to evaluate share price. Three techniques are highlighted in the “Buffettology” book and are used in the Buffett spreadsheet template (Figure 1). You can download the spreadsheet from at AAII Web site: www.aaii.com/ci/buffettology.xls.

Buffett prefers to concentrate his investments in a few strong companies that are priced well. He feels that diversification is used by investors to protect themselves from their stupidity.

Earnings Yield

Buffett treats earnings per share as the return on his investment, much like how a business owner views these types of profits. Buffett likes to compute the earnings yield (earnings per share divided by share price) because it presents a rate of return that can be compared quickly to other investments.

Buffett goes as far as to view stocks as bonds with variable yields, and their yields equate to the firm’s underlying earnings. The analysis is completely dependent upon the predictability and stability of the earnings, which explains the emphasis on earnings strength within the preliminary screens.

VCA Antech has an earnings yield of 6.5% [cell C13, computed by dividing the current (trailing 12 months) earnings per share of $1.56 (cell C9) by the closing price on May 15, 2009, of $24.04 (cell C8)]. Buffett likes to compare the company earnings yield to the long-term government bond yield. An earnings yield near the government bond yield is considered attractive. With government bonds yielding slightly more than 4% currently (cell C17), VCA compares very favorably. By paying $24 per share for VCA, an investor gets an earnings yield return greater than the interest yield on bonds. The bond interest is cash in hand but it is static, while the earnings of VCA Antech should grow over time and push the stock price up.

Historical Earnings Growth

Another method Buffett uses to value prospective stocks is to project the annual compound rate of return based on historical earnings per share increases. For example, earnings per share at VCA Antech have increased at a compound annual growth rate of 23.9% over the last five years (cell B30). If earnings per share increase for the next 10 years at this same growth rate of 23.9%, earnings per share in year 10 will be $13.34. [$1.56 × (1 + 0.239)10]. (Note this value is found in cell B47 and also in cell E37. Using a calculator, results may differ due to rounding.) This estimated earnings per share figure can then be multiplied by the five-year average price-earnings ratio of 25.0 (cell H10) to provide an estimate of price [$13.34 × 25.0 = $333.19]. (Note this value is found in cell E40.) While VCA does not pay a dividend, if a company you are valuing pays dividends an estimate of the amount of dividends paid over the 10-year period should also be added to the year 10 price. (Note that when evaluating dividend-paying stocks, this value is found in cell E41.)

Once this future price is estimated, projected rates of return can be determined over the 10-year period based on the current selling price of the stock. Buffett requires a return of at least 15%. For VCA Antech, comparing the projected total gain of $333.19 to the current price of $24.04 leads to a projected annual rate of return of 30.1% [($333.19 ÷ $24.04)1/10 – 1]. (Note this value is found in cell E43.)

Sustainable Growth

The third valuation method detailed in “Buffettology” is based upon the sustainable growth rate model. Buffett uses the average rate of return on equity (ROE) and average retention ratio (1 – average payout ratio) to calculate the sustainable growth rate [ROE × (1 – payout ratio)]. For companies that do not pay a dividend, the sustainable growth rate equals the return on equity.

The sustainable growth rate is used to calculate the book value per share (BVPS) in year 10 [BVPS × (1 + sustainable growth rate)10]. Earnings per share can then be estimated in year 10 by multiplying the average return on equity by the projected book value per share [ROE × BVPS].

To estimate the future price, you multiply the earnings per share by the average price-earnings ratio [EPS × P/E]. If dividends are paid, they can be added to the projected price to compute the total gain.

For example, VCA Antech’s sustainable growth rate, based on average five-year data, is 22.3% [22.3% × (1 – 0.0)]. (The sustainable growth rate is found in cell H11.) Again, since the company does not pay a dividend, its sustainable growth rate equals its return on equity. Thus, book value per share should grow at this rate to roughly $65.91 in 10 years [$8.81 × (1 + 0.223)10]. (Note this value is found in cell B62.) If return on equity remains 22.3% (cell H6), in the tenth year, earnings per share that year would be $14.69 [0.223 × $65.91]. (Note this value is found in cell C62 and also in cell E52.)

The estimated earnings per share can then be multiplied by the average price-earnings ratio to project the future price of $366.88 [$14.69 × 25.0]. (Note this value is located in cell E55.) If dividends have been paid, you would use an estimate of the amount of dividends paid over the 10-year period and add this to the projected price to arrive at the total gain. This total gain is then used to project the annual rate of return of 31.3% [(($366.88 + $0.00) ÷ $24.04)1/10 – 1]. (Note this return estimate is found in cell E58.)

Data Sources

For users of Stock Investor Pro, the projected returns based on the earnings growth rate and sustainable growth rate are already built into the program using seven-year data (found in the Valuations data category). For those who do not subscribe to Stock Investor Pro, all of the data you need to populate the Buffett valuation spreadsheet can be found in company 10-K reports, which are available on-line from numerous sources. You will have to search through multiple years, however, in order to get the six years of data required for this spreadsheet. Alternatively, the SmartMoney Web site (www.smartmoney.com) provides 10 years of financial statement data for free.

Conclusion

The Warren Buffett approach to investing makes use of “folly and discipline”: the discipline of the investor to identify excellent businesses and wait for the folly of the market to drive down the value of these businesses to attractive levels. Most investors have little trouble understanding Buffett’s philosophy. The approach encompasses many widely held investment principles. However, its successful implementation is dependent upon the dedication of the investor to learn and follow the principles.

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Warren Buffett My Investment Style Hasn't Changed - Fox Business- 2-22-2010

Warren Buffett - The Philosophy of Berkshire Hathaway

Warren Buffett's investment advice

Warren Buffett (World's Richest Investor): His Secrets Revealed!!!

Buffettology: Value Investing Strategy

Buffettology: Warren Buffett Quotes & Value Investment Strategy for Stock Picks

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While it may be tempting to throw yourself into the dramatic highs and lows of investing in the stock market in search of instant gratification, it’s not necessarily the most profitable choice. Warren Buffet has spent his career watching investors pounce on “hot” companies, only to flounder when the market takes a plunge. All the while, he’s been steadily accumulating wealth by taking an entirely different approach.

You may be thinking, “OK, the guy’s successful, why should I care?” Well, in 2008, Warren Buffett was the richest man in the world with an estimated worth of over 62 billion dollars. This kind of wealth is not a result of sheer luck. He’s gained his enormous fortune using a very specific investment strategy, developed on a basis of long term investing. The great news is that, by learning a little about the way Warren Buffett thinks, you too can enjoy greater success in the stock market.

So what exactly is Warren Buffett’s investment strategy and how can you emulate him? Read on and find out.

Secrets to Investing Success

Since Warren Buffett has never personally penned an investment book for the masses, how does one go about learning his secrets? Luckily, many of his letters to shareholders, books that compile such letters, and insights from those close to him are readily available to the public.

There’s a lot to be gained from his quotes alone. Here are a few sayings that have been attributed to him.

Warren Buffett Quotes on Investing

• “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”
• “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
• “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
• “Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.”
• “If a business does well, the stock eventually follows.”
• “Price is what you pay. Value is what you get.”
• “Time is the friend of the wonderful company, the enemy of the mediocre.”

Clearly, Warren Buffet is a value investor. He looks for great companies, or “wonderful” ones as he puts it. He is not looking at hot sectors or stocks that may shoot up now, only to cool and fall later. He wants an efficient running business that has favorable long-term prospects.

Additionally, although he wants great stocks, he does not want to pay a premium price. Warren uses a specific calculation to arrive at a fair valuation, then waits until a market correction or crash puts those prices on his doorstep.

Now that you know a little about his basic investing philosophy, let’s take a more in-depth look at how he makes investment choices.

Buffettology and Stock Selection

The book, Buffettology, is a fantastic resource, primarily written by Warren Buffett’s former daughter-in-law, Mary Buffett. The co-author, David Clark, is a long-time friend of the Buffett family. Since these authors probably have some special insight into how Warren Buffet privately analyzes stocks, it’s worth hearing what they have to say. Here are a few of the major points they focus on:

Best Stock Industries

The authors of Buffettology recommend looking for promising companies in 3 broad categories:

1. Consumables
Buffett’s choice businesses include those that make products which are consumed or quickly wear out such as:

• Snacks
• Pop
• Gum
• Toothpaste
• Pens
• Razor blades

Why? Because higher product turnover implies more revenue for the company. If you can also find a leading name brand that people gravitate towards, you have a good starting point.

2. Communications
Another major category of companies that Warren likes is communications. Advertising agencies are a major part of this group as they expand into new platforms like cell phones and tablet computers, in addition to the old standbys of TV, radio, and newspapers.

This is an area where you will need to be careful because what is new today can be discarded as waste tomorrow. Be aware that advertising may go down with the economy as businesses prune costs during tough times. Also, as people turn from print to web, some forms of advertising will increase at the expense of others.

3. Boring Services
The last category is for repetitive and boring services. A few examples of these highly profitable companies doing the same job over and over might be:

• Lawn care companies
• Janitorial services
• Basic tax filing services

“Boring” itself is not enough to warrant an investment. However, if something is both boring and essential, there’s a good chance it’s a stable, efficient, easy-to-operate business that will have a long-lasting life.

What Characteristics in a Company to Look For

Once you know where to look, it’s important to know who you should turn your attention to. The book cites the following factors for determining which companies to watch closely.

1. Existence and Value
Warren Buffett analyzes considerable historical financial data on a stock. In general, this would exclude new companies where only a few years of financial data exist. He picks stocks based on their intrinsic value and the ability of the company to continually increase that value, often wanting a minimum of 15% annually over many years. This kind of regular increase can be considered a High Annual Rate of Return.

2. Market EdgeThis includes companies that have a monopoly, where no other alternative exists. Think of a toll-bridge as one example. Other market edges could include companies that sell a unique product. Buffett is not as keen on commodity-based companies where the price is set by the market, competition is stiff, and the company has no ability to freely adjust for inflation.

3. Finances
Warren looks for these financial traits in companies:

• Increasing Earnings. It is especially important that a large amount of this money is being retained and used for further growth. Sitting on a big pile of cash, or giving earnings back as dividends, is not viewed as desirable since extra tax may need to be paid on dividends, and the burden of re-investing is placed on the shareholder.
• Reasonable Financing. The financing for the company should be reasonable, without a high debt-load.
• Simple Business Model. The company model should be simple with few moving parts, and not a lot of money needed to maintain the business model. It should be a lean, mean, and profitable operation.

But when you find such a wonderful company, how will you know if it is a good buy? For that we need to learn how to value a stock the Buffett way.

Valuing a Company Buffett-style

Buffettology also outlines a few different methods to determine the value of a stock and whether or not it is a good buy. Two of the most popular methods revolve around “Earnings Yield” and “Future Price Based on Past Growth.”

1. Earnings Yield

The concept behind this is elementary and rooted firmly in the price-to-earnings ratio, or more correctly, the opposite, which is called the earnings yield. When you divide the annual earnings by the current share price, you find your rate of return. Therefore, the lower the stock price is in relation to its earnings, the higher the earnings yield. Here are three examples for comparison:

• Aeropostale Inc. (NYSE: ARO) has a share price of around $25 and an annual earnings of $2.59. If you divide $2.59 by $25 you get the earnings yield of 10.36%.
• Hansen Natural Corporation (NASDAQ:HANS) has a share price of $56 and an annual earnings per share of $2.39 and only 4.2% of the share price is annual earnings.
• McDonald’s is trading at a $75 with annual earnings of  $4.62 per share, which gives us an earnings yield 6.2%.

Warren would use this formula to compare similar stocks with steady earnings to see which would provide a higher earnings yield based on share price. Based on these examples, Aeropostale has the most attractive earnings yield.

Keep in mind, this is only to be used as a very quick and crude method of comparing similar stocks, or to compare yields to bond rates. As you will see in the next two valuation methods, the earnings yield is far from accurate in giving us a long-term growth rate.

2. Future Price Based on Past Growth

For this, Buffett would analyze the long-term growth trend to determine how it might perform over the next 10 years. Depending on the company and the industry, it may make sense to use any of a variety of metrics, including both the PE ratio and the Enterprise Value/Revenue multiple.

Let’s use the PE ratio to illustrate how this strategy works. To guess what growth might be like over the next 10 years, you first need to determine what the average earnings growth rate has been on the stock over the past 5 to 10 years.

I will use McDonald’s as an example. They are a big name brand, they aggressively opened up in new markets, and McDonald’s provides a consumable product that has a loyal following. Let’s say the EPS growth over the past 5 years averages 17.6%. Using an EPS of$4.62 EPS in year 0, and a growth rate of 17.6% per year, will yield the following 10-year forecast:

• Year 0, EPS: 4.62
• Year 1, EPS: 5.43
• Year 2, EPS: 6.39
• Year 3, EPS: 7.51
• Year 4, EPS: 8.84
• Year 5, EPS: 10.39
• Year 6, EPS: 12.22
• Year 7, EPS: 14.37
• Year 8, EPS: 16.90
• Year 9, EPS: 19.88
• Year 10, EPS: 23.37

Now you have an estimated total earnings per share by the end of year 10. Today, the EPS is $4.62 and in a decade that should appreciate to $23.37.

Now, you must determine what this means for the share price. To do this, you simply look to a long-term average of P/E, or the price-to-earnings ratio. The 5 year P/E average in this example is 17.7. Multiply this by the future expected earnings rate of $23.37, and you get an estimated price of $413.65.

If the price right now is $75, what is the rate of return over the next 10 years?

You can simply use an online rate-of-return calculator to calculate annual profits of 18.62%. Remember, this is a basic estimate that doesn’t include dividends, which can boost your yield by 3% every year, or almost 22% when using capital gains and dividend yield together. Moreover, it is based on the assumption that the PE ratio will remain constant, which is unlikely, but still serves as a good example

For those of you who find all of this a little overwhelming, that doesn’t mean that Buffett-style investing isn’t for you. There is a simpler option.

Berkshire Hathaway

If you want to utilize his strategies without actually having to learn them, you can buy shares in Warren Buffett’s company. He is the Chairman and CEO of the publicly owned investment managing company, Berkshire Hathaway. Take advantage of his success by choosing from the following:

• Class A Shares with a current sticker price of $127,630 each.
• Class B Shares which currently sell for $85.04 each.

As you can probably tell from the price discrepancy, it takes 1,500 Class B shares to have equivalent ownership of one Class A share. They are similar except that Class A shares have proportionally more voting rights per dollar of worth.

How have the shares of Berkshire Hathaway performed over the past 46 years? The cumulative gain is 490,409% which works out to an average of 20.2% per year. This is an average annual 10.8% excess of the market as tracked by the S&P 500 index (including dividends). If in 1965, you invested a whopping $1,900 with Warren Buffett, this would be worth $9,545,300 by the end of 2010.

Effects Of Success

With those numbers, you may be wondering why anyone would choose to attempt Warren’s strategy on their own. Unfortunately, this kind of incredible growth is becoming harder for Berkshire Hathaway to attain. When a company has hundreds of billions of dollars in revenue, achieving significant growth is far more difficult.

Buying up smaller companies did not impact Warren Buffett’s Berkshire’s financials as much as when his company was smaller. He has become an elephant stomping around the market in search of increasingly elusive good buys.

Final Word

The simplest way to invest Warren Buffet style is to buy shares of Berkshire Hathaway and forget about them for the next 10 or 20 years. But, as his company has reached astronomical heights, this strategy has become less and less valuable.

Thus, many people who love the “Warren Buffett investing style” choose to invest on their own. If you are excited by due diligence, scanning thousands of stocks for that highly profitable (and oftentimes mundane) business, forecasting company earnings, and monitoring the company’s progress, then the “Warren Buffett investment method” may be a perfect fit for you. Remember, perhaps above all else, to have guts of steel when the market drops so that you can buy undervalued and profitable stocks.

What are your thoughts on Warren Buffett and his investing style? Do you try to replicate his strategies and success? Share your experiences in the comments below.

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