Billionaire investor and chair of Berkshire Hathaway Warren Buffett is known for investing in companies with intrinsic worth but undervalued by the market. He is seldom concerned with the stock market movements or the supply/demand factors and seeks ownership in quality businesses with the potential to generate revenue consistently.
How does Buffett determine the intrinsic value of businesses? The answer lies in evaluating the company’s fundamentals.
Return on Equity (ROE)
ROE, or a shareholder’s return on investments, offers a glimpse into a company’s profitability and how efficient the leadership is at generating income and growth.
This measure of financial performance is determined by dividing net income by shareholders’ equity. Simply put, ROE tells you the rate at which investors earn income on their shares.
Buffett looks at ROE, or the return on net assets, to understand how a business has performed relative to its industry peers.
Profit Margins
Profit margin is determined by dividing net income by net sales, where a high margin means a company may be carrying out business activities well and keeping expenses under control.
In other words, it is a part of revenue from sales that a business retains as a surplus after all expenses. A company with a 10% profit margin saves $0.1 per dollar of sales.
However, a good profit margin isn’t enough. The measure of profitability also means how well a company can increase its margins.
Buffett has viewed profit margins as a way to understand if a company is willing to trim unnecessary expenses to focus on core business verticals.
Company Debt
Buffett likes companies with less debt. It means he is looking for companies with earnings growth driven by shareholders’ equity rather than borrowed money or low debt-to-equity ratios.
The debt-to-equity ratio is the company’s total liabilities upon shareholders’ equity. It offers insights into whether a company uses more debt or equity to finance its operations and assets.
A high debt-to-equity ratio means higher interest payments, volatile earnings, and a company relying too much on debt to grow or sustain. Investors often calculate this ratio, emphasising long-term debt because it carries higher risks than short-term liabilities.
However, a history of a very low debt-to-equity ratio can also mean a business is not leveraging the advantages of debt financing for expansion.
Commodity Reliance
Buffett tends to avoid businesses with products indistinguishable from its competitors or that rely on a single commodity like oil or gas.
While this is not always the case, he has often expressed caution around investing in commodity-reliant businesses, believing they generally lack a competitive edge, are volatile, and have almost no influence over commodity price changes.
Buffett thinks companies must be low-cost producers if they sell products with commodity-like economic traits. However, a business with a low-cost edge must also “pursue an unrelenting foot-to-the-floor strategy.”
“We do not have a bias toward any commodity-related business. If we have any bias, it’s against,” according to Buffet.
Is The Company Cheap?
Finding out if a good company is undervalued is an important skill Buffett has mastered over decades. His investment philosophy targets firms trading below their intrinsic value and comparing it with their market capitalisation.
While his consistent accuracy over time requires a long-term perspective, one popular metric investors check to understand if a company is undervalued or overvalued is the price-to-earnings ratio (P/E).
The ratio of the stock price to the earnings per share indicates if a stock at its current trading levels is cheap or expensive. The P/E ratio tells you how much you must invest in a stock to receive $1 of that company’s earnings. A higher P/E ratio means a company is overvalued, and the stocks are expensive.
The Oracle of Omaha’s ultimate lesson for all traders is that investing in good companies and making returns hinges on your commitment and effort to invest in yourself first by developing skills people are willing to pay for.
Disclaimer: Our digital media content is for informational purposes only and not investment advice. Please conduct your own analysis or seek professional advice before investing. Remember, investments are subject to market risks and past performance doesn’t indicate future returns.
