Buffett’s 7 Filters

Anybody who has read anything about Warren Buffett knows he is superbly wealthy and has made all his money through his investment in stocks,that he is a value investor,that his favourite holding period is forever and that he loves his companies to have ‘big moats’.Following are a list of parameters that Buffett uses to evaluate companies.They are from the book ‘The Guru Investor’ by John P. Reese.Why not use these parameters to check out a company before buying its shares?

 STABILITY OF EARNINGS:This can be checked by considering the earnings per share (EPS) for the past 10 years. EPS is derived from the residual profit left after payment of all expenses, taxes, depreciation, interest, preference dividends and belongs entirely to equity shareholders. A company should not have a negative EPS in the past 10 years. If the EPS is lower than that in the previous year, the dip should not be more than 45%.

DEBT TO EARNINGS RATIO: The second variable is the level of long-term debt to earnings ratio. Buffett likes conservatively financed companies. He prefers the long-term debt of a company to have been paid off from its net earnings in less than five years. This implies that the long-term debt to earnings ratio should be less than or equal to five.

RETURN ON EQUITY (ROE): The third variable measures how much money a company earns on its equity. The ratio is generally expressed as a percentage. For a company to figure on Buffett’s radar, its 10-year average ROE should be greater than or equal to 15%.

RETURN ON TOTAL CAPITAL (ROTC): This variable can sometimes give an incorrect picture. It’s because some companies have a high debt content in their capital structure in relation to their equity. Still, they will show a high ROE because of the low equity base. However, a high debt content makes the company risky as the debt needs to be serviced, irrespective of the company being profitable or not. ROTC overcomes the limitation of ROE. Buffett prefers the companies whose 10-year average ROTC is greater than or equal to 12%.

FREE CASH FLOW: Buffett does not pick stocks of companies that indulge in major capital expenditure. Free cash flow is the difference between operating cash and capital expenditure. Therefore, free cash flow should be a positive. A company with a positive free cash flow is generating more cash than it is consuming and this is a good sign.

RETURN ON RETAINED EARNINGS: The next variable is the return on retained earnings. Buffett uses this to assess the management’s performance. The variable gives an indication of the ability of the management to use retained earnings for shareholders’ wealth creation. To be eligible for investment by Buffett, a company’s 10-year return on retained earnings should be greater than or equal to 12%.

MARKET SHARE:Buffett uses one more filter while identifying companies- market share. He prefers the companies that have an overwhelming market share and are dominant players in their fields. Market share is an important consideration because it ensures sustained profits for the company.