Warren Buffett is the CEO of Berkshire Hathaway and one of the greatest investors of all time. This article presents some of his methods and the financial indicators he uses when trading stocks. But before moving along, these are some ground rules of the legendary investor.

 

Warren Buffett’s Ground Rules

• 70/30 Rule (Invest 70% of your money and save 30%)
• Investing requires long-term thinking -Buy only something that you'd be perfectly happy to hold for 10 years
• Don’t try to predict the market -Uncertainty is the friend of the buyer of long-term values
• Focus on the "Deep Value" of businesses and have something to compare it against -Price is what you pay; value is what you get
• Good investment is based on the industry’s prospects and the ability of the management to exploit future opportunities
• Pay attention to the corporate earnings yield and compare it to the bonds yield -Wait for the stock price to reach the desired level of a long-term rate of return

 

The analysis starts with the Buffett Indicator, which is considered the best single measure of where equity valuations stand.

 

 

1st Step: The Buffett Indicator

 

The Buffett Indicator is the ratio of total US stock market capitalization divided by GDP and can help investors understand where equity valuations stand.

□ Buffett Indicator = Total US Stock Market Cap / US GDP

The current Buffett ratio is 193%, about 60% above the historical trend line, meaning that the stock market is overvalued relative to GDP.

• As of October 2024, the Buffett ratio is: $55.253T/$28.56T= 193%

 

2nd Step: Comparing Corporate Earnings Yield to Government Bond Yield

 

Buffett likes to compare certain stocks' earnings yield to long-term bonds' yield. This can be explained as bonds constitute an alternative investment to stocks. Historically, these two asset classes are correlated. Specifically, bond prices are positively correlated to stock prices, and bond yields are negatively correlated.

 

Formula:

□ Earnings Yield = Earnings Per Share (EPS) / Stock Price

• Buffett argues that bonds and stocks can be valued similarly
• Based on a historical context, the earnings yield can provide insight into the ability of a corporation to generate profits
• If the earnings yield is close to a government bond yield is considered attractive

 

3rd Step: Focusing on a few Strong Businesses

 

The third step is to pick some good businesses and focus on their financial statements. Buffett prefers to select a few strong companies priced well rather than analyzing too many companies. He generally ignores diversification practices as he feels that wide diversification is only required when investors do not understand what they are doing.

• Selecting the strength of the few by ignoring the benefits of a wider diversification
• Interested only in companies that have been in the market for at least one decade
• Focusing on the industry’s outlook and the proven management’s ability to exploit opportunities
• Waiting for the stock price to reach the desired level of a long-term rate of return

 

Filtering Stock Picks Based on Financial Statements

 

These are some key Warren Buffett filters based on the corporate financial statement:

■ Gross Margin > 40% (The percentage of revenue after subtracting the cost of goods sold)

■ Net Income Margin > 20% (After-tax income as a percentage of sales)

■ SG&A Margin < 30% (The company’s general, selling, and administrative costs as a percentage of net revenue)

■ Debt to Equity ratio < 0.5 (Dividing the company’s total liabilities by its shareholder equity -More later)

■ Current ratio > 1.5 (Highlights the company's ability to meet its short-term obligations -More Later)

■ Interest Expense Margin < 15%

■ Price-to-FCF Ratio (Market Cap to Free Cash Flow -More later)

■ Return on Net Tangible Assets (RONTA) > 20% (The return on net tangible assets -More later)

■ Return on Equity (ROE) > 20% (The stockholder’s return on investment -More later)

 

4th Step: Calculating the Compound Annual Growth Rate & Stock’s Expected Return

 

Buffett pays a lot of attention to the compound annual rate, a rate that is based on corporate earnings. Let’s see how we can use the compound annual rate to price stocks.

 

Using the Compound Annual Rate the Buffett Way

The compound annual rate formula can be expressed in many ways. This is one of the ways it may be expressed:

 

Formula:

□ Compound Earnings = EPS * { (1 + EGR) ^ T }

Where:

EPS = Current earnings per share

EGR = Average growth rate of corporate earnings of the past 5-10 years

T = Number of periods (Years)

 

Example:

Let’s suppose there is a fast-growing company X showing the following figures:

• $3.0 earnings per share (EPS)
• 20% average earnings growth over the past 10 years

Based on the above formula, we can calculate the compound earnings for the next 10 years:

□ Compound Earnings = $3.0 * { ( 1+0.2 ) ^ 10 ) ] ≈ $3 * 6.1917 ≈ $18.575

• This means that company X is expected to have $18.575 in earnings per share (EPS) at the end of the decade (year 10)

 

 

Using P/E ratio to Price Stocks Based on their Compound Earnings

The compound earnings can be used for pricing stocks. This is how:

 

(1) Starting by multiplying the compound earnings by the historical P/E ratio

 

Formula:

□ Compound Earnings * Historical P/E

In our previous example, company X was expected to have $18.575 EPS after ten years. Now, let’s suppose that the stock of company X has a historical average P/E=15.

□ Compound Earnings * P/E = $18.575 * 15 = $278.625

 

(2) Calculating the Expected Rate of Return for the Stock

 

The next step is to compare this figure ($278.625) to the stock's current price. In this way, we can calculate the company’s X stock expected annual rate of return. Let’s suppose the price of the Company X stock is $50.

Note: To this figure ($278.625) we could add the estimated dividends paid for the next 10 years. However, to keep things simple we are NOT going to add dividends and assume that dividends cover inflation and the dollar's loss of purchasing power.

 

General Formula:

□ { ( Compound Earnings / Share Price ) ^ ( 1 / T ) } – 1

 

In our example:

□ { ( $278.625 / $50 ) ^ ( 1 / 10 ) } – 1 = ( 5.5725 ^ 0.1 ) - 1 = 18.74%

• The expected rate of return of the stock is 18.74%
• Buffett requires a return of at least 15%, therefore, the stock of company X looks attractive

 

Going Deeper into Buffett’s Financial Indicators

Warren Buffett uses various financial indicators to filter out investment opportunities. These are some of his indicators worth mentioning.

 

1. Return on Equity (ROE)> 20%

ROE refers to the stockholder’s return on investment and is calculated as follows:

Formula: ROE = (Net Income / Shareholder’s Equity) X 100

Buffett uses ROE to compare the performance of companies in the same industry.

• ROE should be monitored on a historical performance basis of 5 to 10 years.

Buffett wants the average ROE for the past 10 years above 20% and no year in the past 10 years to be less than 15%.

 

2. Return on Net Tangible Assets (RONTA) > 20%

RONTA measures the return on net tangible assets. The indicator can highlight the company’s ability to generate profits without using expensive assets and excessive debt.

Tangible assets refer to all physical assets on a company's balance sheet, such as:

• Property, plant, and equipment (PP&E)
• Office equipment (HW/SW)
• Raw materials
• Finished goods

Formula: Net Income / Net Tangible Assets

Where:

■ Net Tangible Assets = Total Assets - Total liabilities - Intangible assets

Buffett prefers RONTA to be above 20%.

 

3. Debt-to-Equity (D/E) Ratio < 0.5

The debt-to-equity (D/E) ratio evaluates the financial leverage of a corporation. It is calculated by dividing total liabilities by shareholder equity.

Formula: Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity

The higher the ratio, the more a company is financed by debt rather than equity. Buffett prefers to invest in companies that can generate profits without needing to borrow too much money.

Buffett wants a Debt-to-Equity Ratio below 0.5.

 

4. Current ratio > 1.5

The current ratio highlights the company's ability to meet its short-term obligations.

Formula: Current Ratio = Current Assets / Current Liabilities

The current ratio provides insight into how well the company can handle its debt obligations for the next 12 months.

Warren Buffett prefers a current ratio above 1.5.

 

5. Free Cash Flow (FCF)

Free cash flow refers to the available money that a company has to repay its creditors and pay dividends to its shareholders.

Formula: Free Cash Flow = Cash from Operations – Capital Expenditures

Buffett pays attention to the Free Cash Flows to evaluate the company's ability to generate consistent money for its shareholders. However, Buffett doesn't use Free Cash Flow in isolation, he combines FCF with market capitalization.

Formula: Price-to-FCF Ratio = Market Cap / Free Cash Flow

A low Price-to-FCF ratio is an indication of an undervalued company in the same way that a low P/E indicates an undervalued stock.

 

 

Table: Summarizing Buffett’s Key Indicators & Filters

INDICATOR	FORMULA	FILTER	INDICATOR	FORMULA	FILTER
Return on Equity (ROE)	(Net Income / Shareholder’s Equity) X 100	> 20%	Current Ratio	Current Assets / Current Liabilities	> 1.5
Gross Margin	{(Revenue – Costs of Goods) / Revenue} X 100	> 40%	Debt to Equity Ratio	Total Liabilities / Shareholders' Equity	< 0.5
Net Income Margin	(Net Income / Revenue) X 100	> 20%	Interest Expense Margin	(Interest Expense / Revenue) X 100	< 15%
Return on Net Tangible Assets (RONTA)	Net Income / Net Tangible Assets	> 20%	SG&A Margin (Selling, General & Administrative costs)	SG&A Expense / Net Revenue	< 30%

 

Sources:

• https://en.wikipedia.org
• https://www.theinvestorspodcast.com
• Brian Feroldi “The Motley Fool”

 

■ Warren Buffett Stock Trading Method and Indicators

George Protonotarios, financial analyst

for TradingCenter.org (c) -15th October, 2024