8 Metrics Warren Buffett use to Identify Quality👑

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Warren Buffett once said:

"It is far better to buy a wonderful company at a fair price than a fair business at a wonderful price."

But how does Buffett identify a wonderful company?

A lot has been written about Warren Buffett and his strategy and philosophy on investing. However, there has been almost no writing on the specifics he looks for in a business. It can be hard to take anything concrete out of Buffett’s quotes and talks. This is why I’m writing this article. To give you an idea of what Warren Buffett looks for regarding financial metrics.

My goal is that you will improve your investing process by knowing what the greatest investor of all time thinks about this.

So, based on Berkshire Hathaway’s shareholders’ letters, and the book “Warren Buffett: Investor and Entrepreneur” by Todd A. Finkle, we will explore this subject.

Here are 8 metrics Buffett used to identify wonderful companies:

High intrinsic value

Buffett is known to buy companies far below their intrinsic value to get a margin of safety. He has said that he values companies based on their future cash flows. He primarily uses the price-to-earnings, price-to-operating cash flows, and price-to-book ratio to determine if a business is a bargain.

However, before doing this, he looks at specific financial statement ratios to determine the quality of the business:

1. Return on Net Tangible Assets

Buffett wants the RONTA to be above 20%. These businesses earn high net incomes without using excessive debt.

• Formula: Net Income / Net Tangible Assets

• Buffett's formula for Net Tangible Assets = Total Assets - Total liabilities - Intangible assets

2. Return on Equity (ROE)

Return on Equity tells us how effective the management is at deploying the capital invested by shareholders. A high ROE usually indicates that management is a good capital allocator. Keep in mind, that the ROE can be manipulated by using debt, as it minimizes shareholders’ equity (Total assets - Total liabilities = Shareholders’ equity).

• Formula: Net Income / Shareholder's Equity

Shareholder's equity is the claims shareholders have on the company when all debts are paid.

3. Profit Margins

Buffett is looking for companies that are growing at 10% annually with high profit margins. If margins are expanding over time, it’s even better.

• Formula: Net income / Net sales

High margins can be a reflection of the management's ability to operate the business and the competitive advantage.

4. Earnings per Share

The favorite measure of Buffett to assess growth is earnings per share.

• Formula: Net Income / Shares Outstanding

Earnings per share is useful as it also accounts for the company's share count. A business that buys back shares will increase its EPS if all else stays the same. This is why Buffett watches the earnings per share and not just the earnings.

Allegedly, a large reason for Buffett buying Apple was its cash-generating abilities coupled with its willingness to buy back shares and hence increase its per-share value.

5. Debt to equity

Buffett uses the Debt-equity ratio to determine how leveraged a business is.

• Formula: Total Liabilities / Shareholder's Equity

An ideal DE ratio depends on the industry, however, Buffett prefers a DE below 1. Coupling the D/E ratio with the ROE is essential, as the D/E ratio will give us an idea of how leveraged a business is. For example, if a business has a debt-to-equity ratio of 3, we know that the business has 3 times more debt than equity in the business. This is a highly leveraged business, and in this case, a high Return on Equity is not impressive.

6. Free Cash Flow

FCF is a measure of the cash left after the business has paid off its required investments in working capital and fixed assets.

• Formula: Cash Flow From Operations - Capital Expenditures

FCF is a measure that is used to value the cash flows of a business

Note: You should subtract the stock-based compensation from the FCF figure. Additionally, you could choose to exclude the “growth CapEx” from the FCF, as we want the “Maintenance Capex” required to operate the business, not grow it. Read more about this in our free guide on How to Analyze the Financial Statements.

7. Capital light

Buffett prefers businesses that don't require extensive capital to operate. He prefers capital-light businesses such as See's Candy. Buffett prefers companies that require very little excess capital to operate and grow. These businesses are rare but can make you a fortune.

• Formula: Capital Expenditure / Operating cash flow

The ratio should be below 20% ideally, depending on the industry.

“We still love a business that takes very little capital and earns high returns, and continues to grow, and requires very little incremental capital”.

Warren Buffett

Read my recent article on the subject:

💎Asset-light businesses are superior

8. Retained earnings

Buffett believes retained earnings is one of the most important metrics to consider. Retained earnings are the excess cash a business keeps after paying a dividend. What management decides to do with this excess capital becomes essential to determine if they are intelligent capital allocators, and manage to earn an excess return with the capital.

• Formula: RE = Net income - dividends

The excess cash can be used to:

• Reinvest in the business’ operation — International expansion, new products or services, new factories and so on.

• Pay off debts — The business might have expensive debt that they have to pay a high interest on. Sometimes the best move is to derisk the business.

• Buy back shares — Great capital allocators will do this when the price of the stock is below its intrinsic value. Share buybacks at elevated share prices are not considered intelligent capital allocation.

Look for companies that grow their retained earnings over time and investigate what the management decides to do with the excess capital.

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