How to analyze stocks like Warren Buffett...

This an excerpt from the book 'The New Buffettology' written by Mary Buffett and David Clark. The last chapter of the book gives a detailed step by step approach to analyzing the potential investment like the way Warren Buffett does.

There are three aspects to the approach. One is the Scuttlebutt analysis, looking for qualitative aspects like presence of Durable Competitive Advantage, Integrity of Management, How its product works, Capital Allocation etc, ability of the company to raise prices with inflation etc. Two is the quantitative analysis including EPS history and 10 year earnings growth, ROE history and10 year growth in ROE, ROTC (Return on Total Capital) history and 10 year growth in ROTC, Debt analysis with a focus on Finance Charges Coverage Ratio, Share Buyback history of the company, Costs incurred to maintain Operations etc

Part three of the approach includes Price Analysis. This include attractiveness of the current price and whether the price is comparable to the intrinsic value and if a Factor of Safety is available. Another aspect of this approach is to use the 'Bond Parity Rule' and see how the initial return compares with the return from Treasury Bonds. Finally, analysis of projected annual compounded return consider both 'Equity / Bond' approach as well as 'Per share earnings growth' approach.

Putting it all together is like the 'One Page Summary' that Peter Lynch describes in his book 'One up on Wall Street'

Here is a detailed explanation of each of  these points.

1. Do the company have an identifiable durable competitive advantage (DCA)? 

Describe the DCA of the company in simple language. If you are not able to do that, the company probably do not have a durable competitive advantage. Some of the aspects to consider are, do you know of the key products or services that the company is selling? Do these products or services have good brand image in the market place? Can the company increase prices with inflation etc.

Write a brief note on the DCA of the company.

2. Do you understand how the product or service work?

If you do not understand how the product or service work, you will not be able to determine the chances of it becoming obsolete. Product obsolescence is a real threat that Mr.Buffet is always aware of. If you can't explain in simple language how the product works, do not invest in the company

Write a brief note on how the products / services work.

3. Do you think that the product / service will become obsolete in 20 years? Why?

If you think that the product or service being offered by the company will become obsolete in 20 years, do not buy the stock

Write a brief note on why the product / service will not become obsolete in 20 years.

4. Does the company allocate capital efficiently in the realm of its expertise?

How is the management allocating the capital? If they are acquiring competitors, are they buying other companies with DCA or are they acquiring Price Competitive Companies in the commodities business? List down all the subsidiaries of the company and the nature of business they are in (DCA Vs. Price Competitive). Even if they are acquiring a company with DCA, are they paying a good price for that or are they paying too much? In what direction is management moving?  Are they strengthening their businesses with DCA or are they slowly moving to Price Competitive Businesses?

Write a brief note on the Capital Allocation Policy of the company.

5. What is the company's per share earnings history and growth?

If it is consistently strong, continue with the analysis. If there is a weak year or two ask yourself whether this is a one time event or something that will become the norm. If it is a one time event then continue. If weak or erratic earnings continue, then stop the analysis. If the earnings are consistently strong, calculate CAGR (Compounded Annual Growth Rate) returns of the recent 10 Years and the recent 5 Years. The latter should ideally be greater than the former.

6. Is the company consistently earning a high return on equity?

A company that doesn't earn a high RoE will not grow at a crisp rate. RoE should be 15% or more. If the company is getting a high RoE, calculate the 10 Year Average RoE

7. Does the company earn high Return on Total Capital (ROTC / ROCE)? 

Same logic as that of RoE

8.  Is the company conservatively financed?

How many years of earnings does it take to cover all the long-term debt of the company? This is calculated by dividing the total long-term debt by the net earnings for the year.  The lesser the value, the better. Note that this is different from Debt to Equity Ratio, Interest Coverage Ratio or Finance Charges Coverage Ratio.

What is the value of Long-term Debt / Net Earnings? What is the trend in the last five years?

9. Is the company actively buying back its shares?

Take the number of shares outstanding 10 years ago. Subtract from it the number of shares today. If the number is positive, the company has been buying back its shares and you should look to buy the shares of the company. If the output is negative number, the company has been adding shares and you should avoid the company.

10. Is the company free to raise prices with inflation?

If the price of the products is the same as it was 10 years ago, then probably you are looking at a commodity business. If the price is raising at par with inflation, that is  the kind of company that should be in your portfolio.

11. Are large capital expenditures required to update plant and equipment?

Do the company has to spend a lot of money maintaining their operations rather than developing the existing basis, that means that the company will be always under pressure and threat of being overtaken by a competitor. Always avoid companies that have to spend a lot of money just to maintain their operations.

PRICE ANALYSIS

12. Is the Company's stock price suffering from a market panic, a business recession or an individual calamity that is curable?

These kind of situations offer the best prices and the best opportunity to buy. Always buy when the price is down compare to value. That is the only way to get rich.

13. What is the initial rate of return and how does it compare with return on Treasury Bonds?

This is called Bond Parity Rule. Earnings yield is calculated as EPS / Price per Share. If this value is greater than or equal to the return on US Treasury bond, the stock is a buy (given all the other factors also recommend a buy). If the treasury bond returns are better, the stock might by overpriced.

14. What is the company's projected annual compounding return as an equity / bond?

This can be answered as a mathematical equation. Refer the example below

15. What is the projected annual compounding return using historical EPS Growth?

Let us look at this through an example.

If your expected rate of return is 15, you will avoid the stock. This stock will become attractive when the current market price falls to (634 / (1.15)^10) =  156 which will give a Projected CAGR Return of about 15%.

These are the 10 filters that Buffett uses to analyse and evaluate a potential investment opportunity. You too can learn from the master and earn similar returns if only you also put in that level of effort and commitment.