Buffett checks once a year:
- Return on beginning Equity
- Change in operating margins, debt levels, and capital expenditures needs
- The companies cash generating ability
Business Tenets
Is the business simple and understandable?
Does the business have consistent operating history?
Does the business have favorable long term prospects?
- Franchise business is one that sells a product or service that is needed or desired and has no close substitute and whose profits are not regulated. It possesses the opportunity to withstand inflation by raising prices.
- Commodity business is the worst kind, one that sells a product or service that is indistinguishable from competitors. The only distinction in a commodity business is price. Companies compete on price and sometimes lower their prices to levels below cost to attract market share. These companies are doomed
- A weak franchise business is more favorable than a strong commodity business.
- Coke is considered weak franchise in America but strong internationally (no close substitutes).
- Commodity business will earn above average returns only if it is the lowest cost supplier. GEICO, Freddie Mac, and Wells operate in a commodity market but generate above average returns because they remain the low cost provider.
Management Tenet
Is management rational?
Is management candid with its shareholders?
- Does CEO discuss failure and proclaim the companies prime objective to maximize the total return of shareholders.
Does management resist the institutional imperative?
Financial Tenets
Focus on ROE not EPS
Calculate Owners Earnings
- NI + non cash (depreciation/amortization) – Cap Ex
- Cash generating ability of a business determines its value
Look for companies with high profit margins
- This shows a strong business but also mgmts ability to control cost.
- Companies with high cost tend to remain high cost and low cost companies tend to stay low cost.
For every dollar invested, make sure the company has created at least one dollar of market value.
- This will show not only how strong the company is but how well mgmt has allocated capital
- Take NI and subtract dividends. What is left is RE. Now add a company’s RE over a 10 year period. Find the difference in MV during the same time, 10 years. If your business has been able to earn above average returns on retained capital, the gain in market value of the business should exceed the sum of the company’s RE, thus creating more than one dollar of market value for every dollar retained.
Market Tenet
What is the value of the business?
- Valued at the estimated cash flows expected to occur over the life of the business, discounted at an appropriate interest rate. “Owners earnings”
- If the company has bob around earnings, discount them by the long term interest rate. If they show predictability, discount at long term interest rate – growth rate. It is better to be conservative.
- Buffett uses 30 year treasury rate. If rates are declining, he will adjust higher
Can the business be purchased at a significant discount to its value?
Related Book Notes
