Wednesday, November 5, 2008

The Warren Buffett Way: Chp 4 Part 3: Buying a Business

Financial Tenets:

Warren is guided by the following financial tenets:

1) Focus on return on equity, not earnings per share
2) Use "owner earnings" to understand value
3) Look for high profit margins
4) For every dollar retained, at least one dollar in market value should be created

Buffett warns not to become beguiled by increases in earnings per share. Earnings per share can simply increase because management has retained earnings in the company and now is getting a low rate of return on those retained earnings. According to Buffet, it is the rate of return on the entire equity base that is important to measure.

When looking at return on equity, adjustments need to be made to ensure the returns are sustainable and due to operating activities, not just one-time events. It is also prudent to adjust marketable securities back to a cost value and make a corresponding adjustment to shareholder's equity in order to stabilize the denominator in the return to equity ratio. This will make interpretation of the ratio more precise with regards to how well management has been performing. Lastly, Buffett is not impressed when high returns on equity are the result of deploying significant leverage.

Buffett focuses on "owner earnings" to understand the value of a business. He doesn't just look at operating cash flows because it fails to account for the capital expenditures of a business. High fixed costs businesses often require high capital expenditures, which is exacerbated during inflationary times. Therefore, Buffett looks at owner earnings which is similar to a definition of free cash flow in order to understand the value of a business.

A company's management needs to be able to convert sales into profits. Buffett likes to find management that treats cost controls as an ongoing discipline, not just a part-time endeavor. Buffett muses that the management of low-cost operations often find ways to continue to cut costs while the management of high-cost operations seem to find new ways of spending money. Expenses have a material impact to profit margins, so Buffett understands the value of investing in low cost operations.

Buffett believes that in the short-term, the accuracy of predicting what the financial markets will do is extremely low. However, in the long term, he believes that stock prices will track to the underlying value of a business. Therefore, if the management has deployed additional capital in a company effectively, it should show over a longer-term period in the market price of a company's stock. One quick test to determine how well management has increased shareholder value, is to see if each dollar of retained earnings has at least increased the market share of a company by one dollar or more.

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