The Warren Buffett Way

"According to Buffett, the investor and the businessperson should look at the company in the same way, because they both want essentially the same thing. If you ask a businessperson what he thinks about when purchasing a company, the answer most often given is: 'How much cash can be generated from the business?' Finance theory dictates that, over time, there is a direct correlation between the value of a company and its cash-generating ability. Theoretically, the businessperson and the investor, in order to profit, should be looking at the same variables.

Yearly Checks

Return on beginning shareholder's equity.
Change in operating margins, debt levels, and capital expenditure needs.
The company's cash generating ability.

The Warren Buffett Way

Step 1. Turn off the stock market.
Step 2. Don't worry about the economy.
Step 3. Buy a business, not a stock.
Step 4. Manage a portfoliio of businesses.

Buy a Business, not a Stock

Business Tenets

Is the business simple and understandable?
Does the business have a consistent operating history? - has experienced different economic cycles and competitive forces.
Does the business have favorable long-term prospects?
Best to Worse:
1. Franchise - sells a product that is needed or desired, that has no close substitute, and whose profits are not regulated. A franchise also posses a great amount of economic goodwill.
2. Weak Franchise - has some pricing power that allows it to earn above-average returns.
3. Strong Commodity Business - will earn above-average returns only if it is the lowest-cost supplier.
4. Commodity Business - sells products or services that are indistinguishable from competitors. Little or no economic goodwill. The only distinction is price.

Management Tenets

Is management rational? - what do they do with excess cash? A rational manager will only invest excess cash in projects that produce earnings at rates higher than the cost of capital.
Is management candid with its shareholders
Does management resist the institutional imperative? - beware if managers who justify their actions based on the logic that if other companies are doing it, it must be all right.

Financial Tenets

Focus on return on equity, not earnings per share

Return on equity = ratio of operating earning to shareholder equity
Calculate "owner earnings" - reflects cash-generating ability. Companies with high fixed assets to profits will require a larger share of retained earnings to remain viable than companies with lower fixed assets to profits.
To determine owner earnings:

Add depreciation, depletion, and amortization charges to net income,
then subtract the capital expenditures the company needs to maintain it's economic position and unit volume.
Look for companies with high profit margins - companies with high-cost operations typically find ways to sustain or add to costs, while companies with below-average costs pride themselves on finding ways to cut expenses.
For every dollar retained, make sure the company has created at least one dollar of market value - test of the strenghts of the business and how well management has rationally allocated the company's resources.
1. From the net income, subtract all dividends paid to shareholders. What is left is the retained earnings.
2. Add the company's retained earnings over a 10-year period.
3. Find the difference between the company's current market value and the market value 10 years ago.
4. The gain in market value of the company should exceed the sum of retained earnings.

Market Tenets

What is the value of the business? - The value of the business is determined by the estimated cash flows expected to occur over the life of the business, discounted at an appropriate interest rate. The cash flows are the company's owner earnings.
If owner earnings are bobbing around some constant value, discount by the long-term interest rate. If owner earnings show some predictable growth pattern, the discount rate can be reduced by this rate of growth. (be conservative on growth rate).
Can the business be purchased at a significant discount to its value