Warren Buffett has made quite the name for himself through the use of value investing. In short, he purchases stocks which he believes are being sold at a discount when looking at their intrinsic value and potential. Of course, there are definitely more things that go into his decisions to purchase a stock, but these six questions are a good place to start when evaluating a stock and deciding if it’s worth the time.
1. Has the company consistently performed well?
The first thing to look for is if the company is actually doing well in the market, and how consistent it has been. After all, everyone gets lucky occasionally, but if over a five to ten year basis the company has continually done as good as or better than its competition, then that’s a good sign. This figure, as far as investing goes, is generally referred to as “return on equity” (ROE) and it can be calculated by dividing the net income by the shareholder equity in order to find out the rate shareholders are earning income through the company.
2. Does the company have excess debt?
Buffett has always looked down on debt, and it’s not a good way to run a company. Generally speaking, a company with a lot of debt is not going to be as stable and will not have the kinds of returns Buffett will want on a regular basis. One of the ways to check this is to figure the debt/equity ratio by dividing the total liabilities by the shareholder’s equity. The larger the ratio, the less Buffett is interested.
3. Are profit margins increasing?
There’s no sense in buying a company that’s going under (although Buffett has done that) so it’s important to make sure that it not only has a good profit margin, but will also consistently increase. Profit margin can be calculated by dividing net income by net sales. But Buffett won’t want to be doing that for just a year—you’ll want to look back at least five years.
4. Has the company been around at least 10 years?
Buffett is interested in companies that are stable and have stood the test of time. Startups are a little too risky, and it’s usually difficult to be able to project the future on a company that hasn’t been around and publicly traded for at least 10 years. In that time, the company will have demonstrated its ability to not only stay ahead of the market, but also provide enough shareholder value to make it worth the investment.
5. Does the company rely on a commodity?
Buffett tends to shy away from companies which rely solely on a commodity like oil and gas as it’s hard to determine prices and supply ten years down the road. Additionally, these companies usually have the exact same products as competitors. For a company to be valuable and worth the time, it has to offer something that sets it apart from competitors.
6. Is the stock selling at 25% less than its intrinsic value?
This question is last because it’s easily the most important thing to consider, and it definitely the deal breaker. If a company is not selling at less than its intrinsic value, then it’s not generally something Buffett will leap for. Finding a company that is undervalued is the most difficult part, and there’s not an easy way to do this—Buffett usually looks at things like earnings, revenues, debt, assets, and then compares that to the company’s market capitalization, or worth.