Warren Buffett
- Adam Edwards
- Nov 7, 2024
- 4 min read
Warren Buffett, influenced by Benjamin Graham but evolving his own approach, developed an investment philosophy focused on buying high-quality businesses with enduring competitive advantages at fair prices. Buffett’s approach blends value investing with a focus on quality, favouring long-term holdings in companies with strong, consistent performance.
Warren Buffett’s Investing Philosophy
Invest in High-Quality Businesses with Competitive Advantages ("Moats")
Buffett seeks companies with durable competitive advantages, or “moats,” that protect them from competition and allow them to maintain profitability over the long term. Moats can come from strong brand names, economies of scale, customer loyalty, or unique products.
This focus on quality differs from Graham’s pure value approach, as Buffett is willing to pay a fair price for a great company rather than a bargain price for an average one.
Long-Term Ownership
Buffett is a strong advocate of long-term ownership, viewing stocks as partial ownership in businesses. His ideal holding period is "forever," allowing investments to compound and benefit from sustained business growth.
By holding onto quality companies, Buffett minimises the costs associated with trading and capital gains taxes, letting his wealth grow over time through compounding.
Management Quality
Buffett values trustworthy, capable, and shareholder-oriented management. He seeks leaders who make rational decisions about capital allocation, reinvestment, and expansion.
He looks for managers with integrity, skill, and a genuine interest in building long-term shareholder value, often meeting with them to understand their philosophies.
Intrinsic Value and Margin of Safety
While Buffett is less focused on buying deeply undervalued stocks than Graham, he still calculates the intrinsic value of a business and only invests when the market price is below this value.
He prefers a margin of safety, though he is willing to pay more for quality companies. This approach balances Graham’s margin of safety with a readiness to pay for quality.
Focus on Cash Flow and Return on Capital
Buffett is interested in businesses with strong cash flow and a high return on capital employed. He prefers companies that generate ample free cash flow, allowing them to reinvest in growth, pay dividends, or buy back shares.
His focus on cash flow ensures the business can fund its own growth and return value to shareholders, providing resilience in economic downturns.
Key Ratios and Metrics Buffett Cares About
1. Return on Equity (ROE)
Metric: ROE measures a company's profitability by showing how much profit is generated with each dollar of shareholder equity. It’s calculated as Net Income / Shareholder Equity.
Buffett's View: Buffett seeks an ROE of 15% or higher, indicating that the company can effectively generate profit from shareholders’ investments. High ROE over several years signals efficient use of equity and strong performance.
2. Return on Capital Employed (ROCE)
Metric: ROCE assesses how effectively a company uses its capital to generate profits. It’s calculated as Earnings Before Interest and Taxes (EBIT) / Capital Employed.
Buffett's View: He values companies with a high ROCE, as it demonstrates efficient use of both equity and debt capital. Consistent, high ROCE reflects a company’s ability to sustain profits without over-relying on debt.
3. Profit Margins
Metric: Profit margin measures profitability relative to revenue, calculated as Net Income / Revenue.
Buffett's View: He looks for companies with stable or increasing profit margins, ideally with gross and net margins higher than their industry peers. Strong margins are a sign of efficiency and pricing power, which helps protect the business during economic downturns.
4. Debt-to-Equity (D/E) Ratio
Metric: The D/E ratio compares total debt to shareholders’ equity, calculated as Total Debt / Total Equity.
Buffett's View: Buffett prefers companies with low or manageable debt levels, typically with a D/E ratio below 0.5. Companies with low debt are less vulnerable during economic downturns, making them more resilient.
5. Earnings per Share (EPS) Growth
Metric: EPS measures the profitability per share of outstanding stock, often calculated as (Net Income - Dividends on Preferred Stock) / Average Outstanding Shares.
Buffett's View: Buffett values steady growth in EPS over time, as it shows consistent earnings generation and shareholder value creation. He avoids companies with erratic earnings, focusing on those with sustained and moderate EPS growth.
6. Free Cash Flow (FCF)
Metric: FCF represents the cash generated after operating expenses and capital expenditures, calculated as Operating Cash Flow - Capital Expenditures.
Buffett's View: FCF is a critical metric for Buffett, as it shows the cash available for reinvestment, dividends, and buybacks. Companies with strong FCF are often financially stable and better positioned for long-term growth.
7. Price-to-Earnings (P/E) Ratio
Metric: The P/E ratio compares the price of a stock to its earnings per share, calculated as Price per Share / Earnings per Share.
Buffett's View: Buffett doesn’t rely heavily on the P/E ratio but prefers a reasonable P/E relative to growth prospects. For quality companies, he is willing to pay a higher P/E if future earnings growth supports it.
What Buffett Looks for in Financial Statements
Balance Sheet
Asset Quality: Buffett examines the quality of assets, preferring businesses with strong brand equity, intangible assets, and high return assets.
Debt Levels: He focuses on conservative leverage, assessing if debt levels are low relative to equity and if the company can comfortably service its debt from operating cash flows.
Income Statement
Revenue Growth: Consistent and moderate revenue growth shows that the company’s products or services are in demand.
Cost Control and Margins: Buffett reviews gross, operating, and net profit margins to see if the company efficiently manages costs and maintains a strong profit structure, which contributes to resilience and competitive strength.
Cash Flow Statement
Operating Cash Flow: Buffett values steady, strong operating cash flow, as it shows the company's ability to generate cash from its core operations.
Capital Expenditures: He reviews capital expenditures to assess how much the company reinvests. Capital-light companies with strong cash flow, such as consumer goods businesses, are particularly attractive.
Free Cash Flow: This metric is central, as it indicates how much cash remains for shareholder returns. Buffett values companies with high FCF, as it demonstrates financial health and the ability to self-fund growth.
Summary
Warren Buffett’s approach combines Graham’s value principles with a strong emphasis on business quality, stability, and management integrity. His preference for companies with high ROE, low debt, strong profit margins, and ample cash flow has led him to focus on financially robust businesses capable of generating consistent returns over long periods. This approach emphasises discipline, thorough analysis, and a clear understanding of what makes a business sustainable and profitable.