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What Is Warren Buffett's Investing Style? 3
Financial Measures
The financial tenets are not sophisticated. Buffett looks at return on equity (ROE). Most finance students understand that ROE can be distorted by leverage (the ratio of debt-to-equity) and therefore is theoretically inferior to some flavor of the return-on-capital metric. By return-on-capital, I mean something like return on assets (ROA) or return on capital employed (ROCE), where the numerator is earnings produced for all capital providers and the denominator includes debt and equity contributed to the business. Buffett understands this, of course, but instead examines leverage separately, preferring low-leverage companies. He also looks for high profit margins, which is natural enough.
The final two financial tenets share a theoretical foundation with EVA. First, Buffett looks at what he calls "owner’s earnings". This is essentially cash flow available to shareholders, or technically, free cash flow to equity (FCFE). For Buffett, it is defined as net income plus depreciation and amortization (i.e. adding back non-cash charges) minus capital expenditures (CAPX) minus additional working capital (W/C) needs. In summary: Net Income + D&A - CAPX - (change in W/C). Purists will argue the specific adjustments, but this equation is close enough to EVA before you deduct an equity charge for shareholders. Ultimately, with owner’s earnings, Buffett is looking at the company’s ability to generate cash for shareholders, who are the residual owners.
The final tenet is called the “one-dollar premise”: what is the market value of a dollar assigned to each dollar of retained earnings? This measure bears a strong resemblance to market value added (MVA), the ratio of market value to invested capital.
Value
The last set of tenets is the value tenets, where Buffett sets to work on estimating a company’s intrinsic value. A colleague summarized this well-regarded process as “bond math”. Buffett projects the future owner’s earnings then discounts them back to the present. Keep in mind that if you’ve applied the other tenets, the projection of future earnings is - by definition - easier to do than usual; e.g. consistent historical earnings are easier to forecast.
Buffett also coined the term “moat”, which has subsequently resurfaced in Morningstar’s successful habit of favoring companies with a “wide economic moat”. The moat is the “something that gives the company a clear advantage over others and protects it against incursions from the competition”. In a bit of theoretical heresy perhaps available only to the Sage from Omaha, he discounts projected earnings at the risk-free rate! He defends this by claiming that the “margin of safety” in carefully applying the other tenets pre-supposes the minimization, if not the virtual elimination, of risk.
Summary
Buffett’s tenets constitute a foundation in value investing, which may be open to adaptation and re-interpretation going forward. It is an open question as to the extent to which these tenets require modification in light of a future where consistent operating histories are harder to find, intangibles play a greater role in franchise value and the blurring of industries' boundaries makes deep business analysis more difficult.
By David Harper, (Editor In Chief - Investopedia Advisor)
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In addition to being a writer for Investopedia, David Harper, CFA, FRM is the editor-in-chief of the Investopedia Advisor (the IA). David is also a senior consultant with Sibson Consulting. He has over ten years of experience consulting to chief-level officers and corporate boards on corporate performance, performance measurement, valuation, incentive plan design, stock option programs, and transaction effectiveness. He has consulted several prominent investment management firms, banks, and private equity firms and is also a frequent speaker and writer on issues related to performance measurement and valuation.
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