Warren Buffett is the CEO of Berkshire Hathaway and one of the most successful investors of all time. This article shares some of his core methods and financial indicators for choosing stocks. But before that, here are a few ground rules from the legendary investor.

 

Warren Buffett’s Ground Rules

• 70/30 Rule - Invest 70% of your money and save 30%
• Investing requires long-term thinking – Buy only something you’d be happy to hold for 10 years
• Don’t try to predict the market – Uncertainty can prove an opportunity for the long-term value buyer
• Focus on the "deep value" of businesses and compare it with something solid – Price is what you pay; value is what you get
• A good investment depends on the industry’s prospects and management’s ability to capture future opportunities
• Pay attention to corporate earnings yield and compare it with bond yields – Wait until the stock price reaches the desired level for a long-term return

This begins with the Buffett Indicator, regarded as the best single measure of stock market valuations.

 

 

1st Step: The Buffett Indicator

The Buffett Indicator is the ratio of total U.S. stock market value to GDP, helping investors gauge overall market valuations.

🧮 Buffett Indicator = Total US Stock Market Cap / US GDP

The current Buffett ratio is 193%, around 60% above the historical trend, showing that the stock market is overvalued compared to GDP.

• As of October 2024, the Buffett ratio is $55.253T ÷ $28.56T = 193%. 🔗 Read More: » Valuing the Stock Market with P/E, PEG, and Shiller P/E

 

2nd Step: Comparing Corporate Earnings Yield to Government Bond Yield (🔗 Treasury Bills)

Buffett likes to compare a stock’s earnings yield to the yield of long-term bonds. This makes sense because bonds are an alternative to stocks. Historically, these two asset classes are linked: bond prices tend to move in the same direction as stock prices, while bond yields move in the opposite direction.

Formula:

🧮 Earnings Yield = Earnings Per Share (EPS) / Stock Price

• Buffett argues that bonds and stocks can be valued similarly
• Based on a historical context, the earnings yield can provide insight into the ability of a corporation to generate profits
• If the earnings yield is close to a government bond yield, it is considered attractive

 

3rd Step: Focusing on a few Strong Businesses

The third step is to choose strong businesses and study their financial statements. Buffett prefers selecting a few solid companies at good prices rather than analyzing many. He usually ignores diversification, believing it is only needed when investors don’t fully understand what they are doing.

• Selecting the strength of a few stocks by ignoring the benefits of total portfolio diversification
• Interested only in companies that have been in the market for at least one decade
• Focusing on the industry’s outlook and management’s proven ability to seize opportunities
• Waiting for the stock price to reach the desired level of a long-term rate of return

Filtering Stock Picks Based on Financial Statements

These are some of Warren Buffett’s key filters based on a company’s financial statements:

🧮 Gross Margin > 40% (The percentage of revenue after subtracting the cost of goods sold)

🧮 Net Income Margin > 20% (After-tax income as a percentage of sales)

🧮 SG&A Margin < 30% (The company’s general, selling, and administrative costs as a percentage of net revenue)

🧮 Debt to Equity ratio < 0.5 (Dividing the company’s total liabilities by its shareholder equity -More later)

🧮 Current ratio > 1.5 (Highlights the company's ability to meet its short-term obligations -More Later)

🧮 Interest Expense Margin < 15%

🧮 Price-to-FCF Ratio (Market Cap to Free Cash Flow -More later)

🧮 Return on Net Tangible Assets (RONTA) > 20% (The return on net tangible assets -More later)

🧮 Return on Equity (ROE) > 20% (The stockholder’s return on investment -More later)

🔗 Read More: » Financial Ratios │ » Risk-Adjusted Portfolio Performance Ratios

 

4th Step: Calculating the Compound Annual Growth Rate & Stock’s Expected Return

Buffett pays close attention to the compound annual growth rate, which is based on corporate earnings. Let’s see how this rate can be used to value stocks.

Using the Compound Annual Rate the Buffett Way

The compound annual growth rate can be expressed in several ways. Here is one way to represent it:

Formula:

🧮 Compound Earnings = EPS * { (1 + EGR) ^ T }

Where:

EPS = Current earnings per share

EGR = Average growth rate of corporate earnings of the past 5-10 years

T = Number of periods (Years)

Example:

Suppose there is a fast-growing company, X, with the following figures:

• $3.00 earnings per share (EPS)

• 20% average earnings growth over the past 10 years

Based on the above formula, we can calculate the compound earnings for the next 10 years:

□ Compound Earnings = $3.0 * { ( 1+0.2 ) ^ 10 ) ] ≈ $3 * 6.1917 ≈ $18.575

• This means that company X is expected to have $18.575 in earnings per share (EPS) at the end of the decade (year 10)

 

 

Using the P/E ratio to Price Stocks Based on their Compound Earnings

The compound earnings can be used for pricing stocks. This is how:

➊ Starting by multiplying the compound earnings by the historical P/E ratio

Formula:

🧮 Compound Earnings * Historical P/E

In our previous example, company X was expected to have $18.575 EPS after ten years. Suppose that the stock of company X has a historical average P/E=15.

□ Compound Earnings * P/E = $18.575 * 15 = $278.625

➋ Calculating the Expected Rate of Return for the Stock

The next step is to compare this figure ($278.625) to the stock's current price. In this way, we can calculate the company’s X stock expected annual rate of return. Suppose the price of the Company X stock is $50.

👉 Note: To this figure ($278.625), we could add the estimated dividends for the next 10 years. However, to keep it simple, we will not include dividends and will assume they cover inflation and the dollar’s loss of purchasing power.

General Formula:

🧮 { ( Compound Earnings / Share Price ) ^ ( 1 / T ) } – 1

In our example:

□ { ( $278.625 / $50 ) ^ ( 1 / 10 ) } – 1 = ( 5.5725 ^ 0.1 ) - 1 = 18.74%

• The expected rate of return of the stock is 18.74%
• Buffett requires a minimum return of 15%, so the stock of company X appears attractive.

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Going Deeper into Buffett’s Financial Indicators

Warren Buffett uses various financial indicators to filter out investment opportunities. These are some of his key indicators worth noting.

 

1️⃣ Return on Equity (ROE)> 20%

ROE refers to the stockholder’s return on investment and is calculated as follows:

🧮 Formula: ROE = (Net Income / Shareholders’ Equity) X 100

Buffett uses ROE to compare the performance of companies within the same industry.

• ROE should be tracked on a historical basis over a 5- to 10-year period.

👉 Buffett looks for an average ROE above 20% over the past 10 years, with no single year falling below 15%.

 

2️⃣ Return on Net Tangible Assets (RONTA) > 20%

RONTA measures the return on net tangible assets. The indicator can highlight the company’s ability to generate profits without using expensive assets and excessive debt. Note that tangible assets refer to all physical assets on a company's balance sheet, such as:

• Property, plant, and equipment (PP&E)
• Office equipment (HW/SW)
• Raw materials
• Finished goods

🧮 Formula: Net Income / Net Tangible Assets

Where:

Net Tangible Assets = Total Assets - Total liabilities - Intangible assets

👉 Buffett prefers RONTA to exceed 20%.

 

3️⃣ Debt-to-Equity (D/E) Ratio < 0.5

The debt-to-equity (D/E) ratio measures a company’s financial leverage. It is calculated by dividing total liabilities by shareholders’ equity.

Formula: Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity

The higher the ratio, the more a company is financed by debt rather than equity. Buffett prefers to invest in companies that can generate profits without needing to borrow too much money.

👉 Buffett wants a Debt-to-Equity Ratio below 0.5.

 

4️⃣ Current ratio > 1.5

The current ratio highlights the company's ability to meet its short-term obligations.

🧮 Formula: Current Ratio = Current Assets / Current Liabilities

The current ratio shows how well a company can meet its debt obligations over the next 12 months.

👉 Warren Buffett prefers a current ratio higher than 1.5.

 

5️⃣ Free Cash Flow (FCF)

Free cash flow is the money a company has available to repay creditors and pay dividends to shareholders.

🧮 Formula: Free Cash Flow = Cash from Operations – Capital Expenditures

Buffett pays attention to free cash flow to assess a company’s ability to consistently generate money for shareholders. However, he doesn’t use free cash flow alone; he evaluates it together with market capitalization.

🧮 Formula: Price-to-FCF Ratio = Market Cap / Free Cash Flow

👉 A low Price-to-FCF ratio is an indication of an undervalued company in the same way that a low P/E indicates an undervalued stock.

 

 

Table: Summarizing Buffett’s Key Indicators & Filters

INDICATOR	FORMULA	FILTER	INDICATOR	FORMULA	FILTER
Return on Equity (ROE)	(Net Income / Shareholders’ Equity) X 100	> 20%	Current Ratio	Current Assets / Current Liabilities	> 1.5
Gross Margin	{(Revenue – Costs of Goods) / Revenue} X 100	> 40%	Debt to Equity Ratio	Total Liabilities / Shareholders' Equity	< 0.5
Net Income Margin	(Net Income / Revenue) X 100	> 20%	Interest Expense Margin	(Interest Expense / Revenue) X 100	< 15%
Return on Net Tangible Assets (RONTA)	Net Income / Net Tangible Assets	> 20%	SG&A Margin (Selling, General & Administrative costs)	SG&A Expense / Net Revenue	< 30%

 

🔗 Sources:

• https://en.wikipedia.org
• https://www.theinvestorspodcast.com
• Brian Feroldi “The Motley Fool”

 

■ Warren Buffett Stock Trading Method and Indicators

George Protonotarios, financial analyst

for TradingCenter.org (c) -15th October, 2024