How To Identify An Excellent Business – 9 Key Questions from Buffett

25/05/2018

What would Warren Buffett do? It’s the age old question all value-investors ask themselves when it comes to stock picking. Thankfully Warren’s daughter-in-law wrote a book called Buffettology that explores the techniques that have made Warren the world’s most famous investor.

Back in episodes 46, 47 and 48 -“How to think Like Warren Buffett” Parts 1-1, we explore 9 key questions that Buffett always asks when deciding if a company is worth buying. We’ve put these questions on paper for you so you can have a go against a company you might have your eye on.

To get answers to these questions, all you need is access to the companies balance sheets and financial statements, and a bit of an idea of the industry the company is in. You can find this information on the company website, or there is a host of resources such as Google Finance, the Australian Securities Exchange, Yahoo Finance or your brokerage platform.

So here are the 9 questions, and what they mean:

  1. Does the business have an identifiable consumer monopoly? 
    1. This question is asking you to consider the strength of the company’s brand. Does it have a strong brand that keeps customers coming back? Is the brand so strong that it’s competitors find it hard to take market lead? Warren asks himself “how much damage could a competitor do if he didn’t care about money?” Is the company’s brand strong enough to withstand competitors throwing everything at them?
  2. Are the earnings of the company strong and showing an upward trend?
    1. On the balance sheet you need to look for three letters – EPS – or Earnings Per Share. This is the measure used to analyse the earnings of the company. Once you’ve found EPS, look back over a number of years to see if it is in a strong, consistent upward trend. Remember, they key here is trend – not every year has to be higher than the previous, but over time it needs to be going up.
  3. Is the company conservatively financed?
    1. Here we are looking at the level of debt the company has, and if it’s good or bad debt. The general idea is that long-term debt shouldn’t be much higher than 1x current net earnings. Long-term debt you will find in the financial statements, and you will also find current net earnings there too. Of the company has a lot of debt, have a look and try to understand why. Perhaps it purchased another company in the past year, which could be a good thing. If it appears the debt is from poor management, then perhaps it’s best to reconsider.
  4. Does the business consistently earn high rate of return on shareholders’ equity?
    1. Shareholders equity is define as a company’s total assets minus the company’s total liabilities (debt). It’s like the equity in your house. If you bought an investment property for $200,000 and put in $50,000 of your own money and borrowed $150,000, the $50,000 is considered your equity. If you rented the house, after all expenses, the return you made from the rent is known as your return on equity. If you earned $5000 after expenses from the rental income, then your earnings are $5000 from $50,000 invested. This means $5,000/$50,000 = 10% return on (shareholders) equity. So if you invest in a company, just like you invest the $50,000, the earnings the company makes is split across all the shares and you get a return on your investment. Anything above a 12% return is above average.
  5. Does the business get to retain its earnings?
    1. Does the business get to keep its earnings and use it to invest in growing the business, or does it have to pay out large sums of dividends to its shareholders? You can find this information in the financial statements. Just look for ‘dividends’ and ‘retained earnings’.
  6. How much does the business spend on maintaining current operations?
    1. You don’t want a business that has to spend and arm and a leg to keep afloat day to day. You want one that has to spend very little to keep running. The perfect business is one that makes $5 million and spends nothing on replacing its plant and equipment. You can find this information by looking for “operating expenses” in the financial statements. If it’s a large proportion compared to its earning and profits, then perhaps reconsider.
  7. Is the company free to invest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does the management do at this?
    1. This is similar to question 5. Can the company use it’s earnings to buy other companies, or buy some of its own stocks. Take note of the management – this is quite hard to do if you don’t know what you’re looking for, so to be honest, as long as there’s not a lot of news about management getting fired, or lot’s of changes on the board, then you can move onto the next one. It takes time to get used to ‘reading’ the management situation of businesses.
  8. Is the company free to adjust prices to inflation?
    1. As inflation (the cost of goods and services) goes up, can the business change its prices, or is it a commodity business where prices are set by the market? For example, Apple can decide to put up the price of their iPhone each year as the cost of living goes up. No on else makes iPhone, so they have the luxury to do that if they want. However, a miner can’t just put up the price of the coal they sell, otherwise no one would buy it from them. It’s the laws of supply and demand. If the miner overproduces, then it will have to lower the price of coal so it can get rid of excess supply.
  9. Will the value added by retained earnings increase the market value of the company?
    1. Here Buffett is asking if by retaining earnings, and investing back into the business, will this be reflected in the price of the stock. Obviously the hopeful answer is yes, but it’s not always the case. Warren believes that if the company can do most of the questions above, then over time the market will keep pushing up the price of the stock.

And that’s it! Have a crack yourself! It’s not too complicated and it’s a great way to introduce yourself to some important concepts. If you can begin to understand this, then you are well on your way to being a successful investor!

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