“You’ll probably find out in the first five minutes.” – Warren Buffett
When it comes to investing, many look to one of the greatest investors of all time, Warren Buffett. It’s no secret that his principles and strategies have served him well over the years. This blog post details the key factors he considered when deciding which business to buy. As you embark on your investment journey, remember these principles to make smarter, more informed decisions.
How to buy a company like Warren Buffett?
- Stay within your capabilities.
- Look for the economic moat surrounding your business model
- Calculate current and future returns on capital
- Whether you want a business relationship with management
- Business owners must love their business and their industry
- The sector your business belongs to is not as important as the other factors above
stay within one’s capabilities
“Do we really know enough about this to make a decision?” – Warren Buffett
First and foremost, it is essential to know your limits as an investor. Warren often talks about staying within his own “circle of competence”—investing in an industry he understands. Focusing on areas he knows will prepare him to evaluate potential investments and make the right decisions.
For example, if you’re familiar with the tech industry, investing in tech companies makes sense. On the other hand, if you have little experience in the automotive sector, it may not be wise to invest in an automaker. Specific and detailed knowledge can be an advantage in investing.
An economic moat surrounding business models
“The most important thing in evaluating a business is knowing how big the moat is around it.” – Warren Buffett
A key aspect of any business is the ability to fend off competitors and stay competitive. Warren calls this the “economic moat.” This is the barrier that protects companies from rivals. The wider the moat, the more difficult it is for competitors to enter the market and threaten the company’s profitability.
A classic example of a company with a wide economic moat is Coca-Cola. The brand has built an extensive distribution network and customer loyalty, making it difficult for competitors to gain market share. When considering a business to acquire, ensure long-term success Look for a business that has a clear economic moat for you.
Return on current and future capital
Another important factor in choosing which business to buy is the return on capital. This includes assessing how effectively the company is using its resources to generate profits. A high return on capital often indicates that a business has a substantial competitive advantage and can lead to long-term growth.
For example, a company with a return on capital of 20% makes better use of its resources than a company with a return on capital of 10%. Investors will want to look for companies with a high return on capital as they are likely to thrive in the future.
The key to valuing a company is based on return on capital and discounted future cash flows. This is the best indicator of the price of the company as a whole or its shares.
Warren Buffett takes a unique approach to evaluating companies based on two key dimensions: return on equity and discounted future cash flows. By examining these factors, Buffett can determine the intrinsic value of a company. This is important in making sound investment decisions. Let’s dive into each aspect and explore why this valuation method best determines a company’s value and share price.
return on capital
Return on Capital (ROC) measures how effectively a company uses its capital (both debt and equity) to generate profits. It is calculated by dividing the company’s net income by its total invested capital. A high ROC indicates that a company has a substantial competitive advantage and is using its resources efficiently to generate revenue. Buffett believes companies with consistently high returns on capital are likely to grow faster and provide better returns to investors.
discounted future cash flows
A discounted future cash flow method is a valuation technique that involves estimating the future cash flows a company is expected to generate and discounting them to their present value. This helps investors determine the intrinsic value of a company considering the time value of money. This is the idea that a dollar today is worth more than a dollar in the future.
Simply put, the more cash a company expects to generate in the future, the higher its intrinsic value. By comparing this intrinsic value to the company’s current market price, investors can determine if a stock is undervalued or overvalued.
Why this method is the best indicator for valuing a company or its stock
Buffett’s approach to evaluating companies based on their return on capital and discounted future cash flows provides a comprehensive picture of a company’s growth and profitability potential. By focusing on these factors, investors can:
- Identify companies with substantial competitive advantages as evidenced by high return on capital.
- Determine the intrinsic value of a company by considering the time value of money and future cash flow generation. This will help you make better investment decisions.
This method is considered one of the best indicators for valuing a company or its shares, as it takes into account the company’s current financial position and future growth potential. Additionally, by calculating intrinsic value and comparing it to current market prices, investors can avoid overpaying for stocks and increase the likelihood of achieving long-term investment success.
Whether you want a business relationship with management
Investment success is not just numbers. It’s also about the people running the show. When evaluating a business to acquire, it is imperative to consider whether you want to have a business relationship with management.
Buffett does this because Berkshire Hathaway is about to buy an entire company and add it to its corporate conglomerate. However, retail investors can also use this as a filter to see if they own equity in the founder’s and CEO’s company. Jeff Bezos, Elon Musk, and Warren Buffett are great examples of companies stocks you might want to buy based on who runs them.
Take the time to get to know the management team, their track record, and their values. A strong management team can have a significant impact on the success of a business, so it’s important to invest in companies led by people you trust and respect.
Business owners must love their business and their industry
Passion is the driving force behind business success. When looking for a company to invest in, make sure the management team loves the business and the industry. Executives who are passionate about what they do are more likely to focus on growing their company and overcoming obstacles.
A good example of this is Berkshire Hathaway CEO Warren Buffett himself. His passion for investing and commitment to his company have contributed to its incredible success.
The sector your business belongs to is not as important as the other factors above
Staying within your capabilities is essential, but the particular industry your business belongs to is less important than the other factors above. A strong business with a wide economic moat, a high return on capital and a passionate management team can achieve success in any industry.
Don’t just focus on a sector, pay attention to the company’s fundamentals and how it responds to the key principles being discussed. Prioritizing these factors will prepare you to identify viable investments, regardless of industry.
- Stay within your capabilities: Invest in an industry you understand.
- Economic Moat: Look for companies with a substantial competitive advantage.
- Return on Capital: Look for companies that use their resources efficiently to generate profits.
- Business Relationships: We invest in companies led by people we trust and respect.
- Passionate Management: Choose a company with leaders who love their industry.
- Industry is less important: Focus on fundamentals rather than specific sectors.
Remember the Warren Buffett principle when deciding which business to buy. Use Buffett’s Principles of Investing to set yourself up for successful investing. The key to Buffett’s investment and business success is making well-informed decisions based on a solid understanding of the business and its growth potential, with a focus on fundamentals.