I’ve been reading all of Warren Buffett’s letter to shareholders these days, and beginning with the 1982 letter, Buffett lays out five simple criteria for buying businesses or stocks.
This appears for the next few years, and I think presents a useful guide to retail investors to evaluate stocks as well.
Here are the six points from Buffett’s ’82 letter
We prefer: (1) large purchases (at least $5 million of after-tax earnings), (2) demonstrated consistent earning power (future projections are of little interest to us, nor are “turn-around” situations), (3) businesses earning good returns on equity while employing little or no debt, (4) management in place (we can’t supply it), (5) simple businesses (if there’s lots of technology, we won’t understand it), (6) an offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).
The second point is of interest to investors as a way of identifying stocks that can be potential purchases. I have bought several potential turnaround stocks in the past, and if the company actually does turn around then it is a great bet but you usually have to wait for a few years to get the benefit.
I feel that if you own a turnaround company then what you’re really looking for is for the stock to grow three or four times at least else the risk is just not worth the return.
I say this because you see a number of opportunities with companies that are making good profits and double in price when bought low enough that you don’t want to have that low an expectation with a turnaround situation.
Getting back to companies with consistent earning power, you can look at the past record of the company for a number of years and see if the revenues, cash flows, and profits have increased or not, and that can be an easy indicator to shortlist the stocks you can further screen to invest in.
The second part of the statement about debt is also a good parameter. I usually look at that number quite closely and am elated to find a company that has zero long term debt, or has as much cash as it has debt. That’s another parameter you can look at after you have identified a company with steady earnings.
Point number 6 about an offering price is also very good. For a long term investor who views stock purchases as stake in business, you want to ensure that the price you’re paying for that stake is a fair price for what the company is earning.
For people who are not well versed with accounting concepts, this can become overwhelming but I think everyone can look at two numbers very easily and build on them. You can look at the market capitalization of a company and their current profits, and ask yourself will you pay that much money to buy the whole company to get about this much profit every year. This will eliminate many companies because they are priced high. But when you do find some that look priced reasonably, you can then look at the cash flows of the company to further analyze the company and determine is it a fair price or not.