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New Year’s resolution No. 3 for investors – Follow in Warren Buffett’s footsteps

In this four part series on Warren Buffett’s investment process we take a look at author Robert Hagstrom’s useful description of the key identifying factors that Buffett looks for in each of his investments.

In Hagstrom’s book, The Warren Buffett Way, these factors are divided up into 12 tenets. In part one we reviewed the 3 Business Tenets, in part two we reviewed the 3 Management Tenets and in part three we turn our attention to the 4 Financial Tenets.

Financial Tenets

1) What is the Return on Equity?

While many investors focus on the price-to-earnings (PE) ratio as a metric for determining the value of a company, Buffett does things a little differently. Instead Buffett utilises the Return on Equity (ROE) metric to help him identify quality companies that achieve above average rates of return for their shareholders. Buffett believes firms that can maintain above average ROE will outperform in the long run.

While investors can determine ROE for themselves, it is interesting to note that few companies regularly report their ROE. Woolworths (ASX: WOW) reports return on funds employed (ROFE), which is a slightly different metric to ROE but does provide for a consistent analysis of the firm. National Australia Bank (ASX: NAB) and indeed most of the major banks also regularly report their cash ROE to investors.

2) What are the company’s ‘owner earnings’?

Accounting rules require companies to make judgements about how to present earnings results. Sometimes reported earnings don’t give investors the clearest picture of the “real” earnings that an owner can expect to receive. To allow for accounting issues and other matters, Buffett adjusts reported earnings to give himself a clearer picture. These days companies regularly attempt to do this for investors by reporting not only official accounting earnings but also “underlying earnings”. These include adjustments which management think provide investors with a clearer picture.

3) What are the profit margins?

Profit margins are important to all firms. While many industrial businesses operate with profit margins between 5% and 10%, other firms such as SEEK (ASX: SEK) can operate with margins above 20%. For Buffett the key is to analyse profit margins to determine if management is being as efficient as they can be, or if they are being lazy and unfocused on minimising expenses.

4) Has the company created at least one dollar of market value for every dollar retained?

Buffett is exceptionally good at profitably allocating capital and only wants to invest in firms that allocate capital efficiently too. Buffett determines this by analysing whether for each dollar retained by a company, a dollar of market value has been gained.

Some companies have been exceptionally good at creating value for shareholders, plumbing supplies company Reece Australia (ASX: REH) and Carsales.com (ASX: CRZ) are two examples where every dollar retained by the company has led to more than a dollar in market gain.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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