“We probably know in the first five minutes.” – Warren Buffett
When it comes to investing, many folks look for advice from 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. In this blog post, we’ll dive into the key factors he considers when deciding which business to buy. As you venture into your investment journey, remember these principles to make smarter, more informed decisions.
How to buy companies like Warren Buffett?
- Stay within your circle of competence.
- Look for economic moats around their business model
- Calculate returns on present and future capital
- Whether you want a business relationship with the management
- The management must love their business and industry
- The sector the business is in is not as important as the other factors above
Stay Within Your Circle of Competence
“Do we really know enough about this to come to a decision?” – Warren Buffett
First and foremost, knowing your limitations as an investor is essential. Warren often talks about staying within your “circle of competence,” which means investing in industries you understand. By focusing on areas you know, you’ll be better equipped to evaluate potential investments and make sound decisions.
For example, if you’re familiar with the tech industry, it would make sense to invest in tech companies. On the other hand, if you have little experience in the automotive sector, it might not be wise to invest in car manufacturers. The key is to play to your strengths and stay within your circle of competence. Specific and in-depth knowledge can be an edge in investing.
Economic Moats Around Their Business Model
“The most important thing in evaluating businesses is figuring out how big the moat is around the business.” – Warren Buffett
An essential aspect of any business is its ability to fend off competitors and maintain a competitive edge. Warren refers to this as an “economic moat” – a barrier that protects a company from rivals. The wider the moat, the more difficult it is for competitors to penetrate the market and threaten the company’s profitability.
A prime 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 challenging for competitors to take market share. When considering a business to buy, search for those with clear economic moats to ensure long-term success.
Returns on Present and Future Capital
Another vital factor when choosing a business to buy is its returns on capital. This involves evaluating how effectively the company uses its resources to generate profits. High returns on capital often indicate that a business has substantial competitive advantages, which can lead to long-term growth.
For instance, a company with a return on capital of 20% is making better use of its resources than one with a 10% return. As an investor, you’ll want to seek out businesses with high returns on capital, as they’re more likely to thrive in the future.
The key to valuing a company is based on its return on capital and its discounted future cash flows. That is the best metric of the price for the company as a whole or for its stock.
Warren Buffett has a unique approach to valuing companies based on two key aspects: return on capital and discounted future cash flows. By examining these elements, Buffett can determine a company’s intrinsic value, which is crucial in making sound investment decisions. Let’s dive into each aspect and explore why this valuation method best determines a company’s worth or stock price.
Return on Capital
Return on capital (ROC) measures how effectively a company uses its capital (both debt and equity) to generate profits. It’s 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 efficiently uses its resources to generate earnings. Buffett believes that businesses with consistently high returns on capital are more likely to grow and provide better returns for investors.
Discounted Future Cash Flows
The discounted future cash flows method is a valuation technique that involves estimating the future cash flows a company is expected to generate and then discounting them back to their present value. This helps investors determine a company’s intrinsic value by accounting for the time value of money – the idea that a dollar today is worth more than a dollar in the future.
In simple terms, the more cash a company is expected to generate in the future, the higher its intrinsic value. By comparing this intrinsic value to the company’s current market price, investors can gauge whether a stock is undervalued or overvalued.
Why This Method Is the Best Metric for Valuing a Company or Its Stock
Buffett’s approach to valuing companies based on return on capital and discounted future cash flows provides a comprehensive picture of a company’s potential for growth and profitability. By focusing on these factors, investors can:
- Identify companies with substantial competitive advantages, as evidenced by high returns on capital.
- Determine a company’s intrinsic value by considering the time value of money and future cash flow generation, which helps make better investment decisions.
This method is considered one of the best metrics for valuing a company or its stock because it factors in the company’s current financial health and its potential for future growth. Additionally, by calculating the intrinsic value and comparing it to the current market price, investors can avoid overpaying for stocks and increase the likelihood of achieving long-term investment success.
Whether You Want a Business Relationship with the Management
A successful investment isn’t just about the numbers; it’s also about the people running the show. When evaluating a business to buy, it’s essential to consider whether you’d like to have a business relationship with the management team.
Buffett does this as Berkshire Hathaway looks to acquire whole companies to add to its corporate conglomerate. However, an individual investor can also use this as a filter to see if they want to own shares in the company of the founder and CEO. Jeff Bezos, Elon Musk, and Warren Buffett are great examples of stocks in companies you would want to buy based on who was running them.
Take time to get to know the management, their track record, and their values. A strong management team can make all the difference in a business’s success, so investing in companies led by people you trust and respect is crucial.
The Management Must Love Their Business and Industry
Passion is a driving force behind any successful business. When looking for a company to invest in, ensure that the management loves their business and industry. A management team passionate about their work will be more committed to the company’s growth and more likely to overcome obstacles.
A great example of this is Berkshire Hathaway’s CEO, Warren Buffett himself. His passion for investing and commitment to his company has contributed to its incredible success.
The Sector the Business Is In Is Not as Important as the Other Factors Above
While staying within your circle of competence is essential, the specific industry a business is in isn’t as critical as the other factors mentioned above. A strong business with a wide economic moat, high returns on capital, and passionate management can succeed in any industry.
Instead of focusing solely on the sector, pay attention to the company’s fundamentals and how it measures up against the key principles discussed. By prioritizing these factors, you’ll be better equipped to identify promising investments, regardless of their industry.
Key Takeaways
- Stay within your circle of competence: Invest in industries you understand.
- Economic moats: Look for businesses with substantial competitive advantages.
- Returns on capital: Seek companies that efficiently use resources to generate profits.
- Management relationship: Invest in companies led by people you trust and respect.
- Passionate management: Choose businesses with leaders who love their industry.
- Industry matters less: Focus on fundamentals rather than the specific sector.
Conclusion
When deciding which business to buy, remember Warren Buffett’s principles. You’ll set yourself up for investment success using Buffett’s investment principles. Remember, the key to Buffett’s investing and business success is to focus on the fundamentals and make informed decisions based on a solid understanding of the business and its growth potential.[1]