Saturday, February 21, 2009

The Warren Buffett Way: Part V

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Today we look at the financial tenets of Warren Buffett according to Hagstrom.

Financial Tenets
In analyzing the following, always look at multi-year (4 or 5) averages rather than single years. It is much more difficult to manipulate figures over several years than it is for a single year or quarter.

What is the ROE?
Ignore EPS and focus on the ROE. You are looking for companies that consistently achieve high earnings on its equity, as this helps to determine whether it intelligently and rationally allocates capital. Make adjustments to the earnings by valuing marketable securities at cost rather than market value (you want to know how the company performs, not the market generally!), and exclude all capital gains and losses and any extraordinary items that will affect operating earnings. Also, to the best of your ability, remove the effects of leverage - you don’t want companies that improve ROE simply by taking on more debt!

What are the company’s “owner earnings”?
Owner Earnings = Net Income + Depreciation/Amortization - Capital Expenditures and Additional Working Capital needed. This is an imprecise figure because capital expenditures are, by their nature, difficult to accurately estimate, however it is better to be vaguely correct than precisely wrong. Look for consistent growth.

What are the profit margins?
Good managers seek to reduce costs all the time, regardless of whether the profits are high or low. You want to see consistent (or growing) profit margins rather than cycles of low and high, as this indicates management gets lazy at times and lets costs get out of hand. Evidence of cost-cutting programs and restructuring indicates management is not consistent in its cost-cutting focus.

Has the company created at least one dollar of market value for every dollar retained?
This is associated with rational asset allocation. You want to look for companies that only retain excess cash where doing so translates to at least the same amount of market value. This is often a long-term figure, so you want to look at the retained cash over a period of time and consider the company’s market value over the same period. If a company retains earnings for unproductive uses for a long period of time, the market will assign it a lower market value.

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