3 things Warren Buffett looks for in a company before buying

Achieve an above average return by focusing on value

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When buying stock, you should imagine that you are the richest person in the world, and you are going to buy the whole company. That way, buying even one share is not like a lottery ticket; buying 100% is an investment.  For Warren Buffett, the founder of Berkshire Hathaway (NYSE: BRK-B, BRK-A) and one of the richest people in the world, what are some of the things he looks for?

Return on shareholder equity (ROE)

ROE measures the amount of earnings that the equity in the company generates. If you own the whole company, then whatever is left over after paying your debts and liabilities is yours- your equity.  If the net profit is left over after your liabilities for the year, then that amount is added to your equity.

You want that to grow, and ROE shows you the rate. If ROE is 10%, then shareholder equity has been increased by 10%. You would like to have the highest sustainable ROE as possible. Good companies grow, so ideally you want those that have an ROE over 10%.

Good ROE companies include Perpetual (ASX: PPT), Commonwealth Bank (ASX: CBA) and Seek (ASX: SEK)

Historical Earnings

Because we can't predict the future, finding companies with steady earnings and earnings growth is crucial to estimate where a company might be in 5-10 years.  Apart from the most recent earnings per share (EPS), you want to see that past years' EPS have been all or mostly positive and ideally growing at fair rate.  Historical earnings need to be stable, like the past performance of an athlete. Would you rather own stock in a pro like Tiger Woods or somebody who occasionally may win a local golf tournament?

Ramsey Health Care (ASX: RHC) is an example of a steady earnings grower, going from $0.21 a share to $1.23 EPS since 2005.

Long-term debt to net earnings

This shows the financial strength of a company to ride out a down market and service its debts when money could get tight. If you have a $500,000 house, and you don't have enough to pay the mortgage, you can't slice off a bathroom, sell it, and pay the bank.  Likewise a company can sell off assets to cover debt, but at bad economic times, the assets could go at fire-sale prices, and outdated inventory or equipment could be a liability more than an asset.

You usually pay your debts from your accrued earnings, so how fast could you pay off your loans? A good company should not have more than 5 times long-term debt to net earnings. Most companies have debt so that isn't bad, but when it becomes excessive and repayments take more and more of earnings, then a company needs a good buffer. Its competitive advantage is durable.

Woolworths (ASX: WOW) has a ratio of 1.89, so if it wanted to, it could pay out its long term debt in 1.89 years, so that is durable enough. Flight Centre (ASX: FLT) has a ratio of 0.01- $2.6 million in long-term debt against $246 million in net profits in 2013.

The Foolish Takeaway

There are other signs that Buffett looks for in a company, but by imitating him with just these three, you weed out the so-so businesses that may not have the staying power or growth potential that you need as a long-term investor.

Start out with value and look for growth, and the good choices will rise above the rest.

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More reading

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Motley Fool contributor Darryl Daté-Shappard does not own shares in any company mentioned. 

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