Buffett’s six criteria for business acquisition

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 

        (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.

3 thoughts on “Buffett’s six criteria for business acquisition”

  1. Nice Read !!!
    But can we really rely on Books ???
    The cash n Debt level they show are really so ???? , post satyam I always get this doubt over books. Satyam was awareded Golden Peacock award for best disclosures.
    NSEL was another shock

    Anyways, those who can trust the financial presented by companies can use http://www.quantspartner.com/ which has lot of financial data, for a particular company as well as for a specified parameter for all companies.

    1. Just adding one more eye opening read
      Investors in Indian Equities believe the audited accounts at their own peril !

      Subodh Kumar Agrawal is the President of the Institute of Chartered Accountants of India.He is also serves on the board of Guj Nre Coke .
      Now, the auditors of the Australian Subsidiary (Guj Nre Coking Coal Ltd) is Grant Thornton.Unlike Indian auditors( see here & here), they seem to have integrity.They refused to give an opinion on the accounts for the year, citing doubts over company’s ability to survive as a ‘going concern’, and inadequate information about its ability to repay debts.

      The Australian unit has reported a loss of A$112 million and faces a working capital deficit. It has breached loan covenants, owes money to creditors and has not provided any evidence to indicate that it has the ability to raise money to replace existing debts, the auditor says.
      The firm owes about A$27.8 million to its ultimate parent and there are doubts whether that money can be recovered. There are similar issues over contingent liabilities, the audit firm has said. Gujarat NRE Coking Coal has to pay A$487.8 million of debts within the year.-from ET

      Now what is shocking is that the true state of affairs of the Australian Subsidiary were hidden from Indian shareholders.The consolidated statements year-ended March 2013 have been prepared only on the basis of unaudited accounts of the subsidiary, which actually accounts for 63% of assets of the Kolkata-based NRE Coke.

      Now as per regulatory filings made by Guj Nre Coke to Indian Stock Exchanges,

      The Consolidated Audited Financial Statement of the Company for the financial year 2012-13 were reviewed by the Audit Committee at its adjourned meeting held on 30th May’2013 and the same were adopted by the Board of Directors at its adjourned meeting held on the same date.The above Audited Consolidated Financial Statements has been prepared based on the available Management Approved Financial Statements of all the Australian Subsidiary Companies including Gujarat NRE Coking Coal Ltd., which has also filed the same results to the Australian Securities Exchange (ASX).

      Now, Indian shareholders can be forgiven for thinking that even the overseas subsidiary accounts were audited.Notice the clever wording “Management Approved Financial Statements of Australian Subsidiary Companies”

      So which genius headed the Audit Committee which did this masterful coverup?Well, none other that the much respected and much loved ICAI President Subodh Kumar Agrawal !
      So, repeat after me, dear readers,Investors in Indian Equities believe the audited accounts at their own peril !

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