When Warren Buffett began his record setting career as one of America’s most well known and successful investors, he followed a simple set of criteria for his nonstop pursuit of company greatness. This three part series will briefly investigate his time tested, systematic method of company analysis. In doing so, it will cover the basic fundamentals that Warren searches for when he takes a look at a company’s financial statements. Starting with the income statement, moving to the balance sheet and finishing with the cash flow statement, this article series will help investors no matter what their current level of expertise.
What does Warren Buffett look for in a company?
To put it quite simply, Warren looks for three basic company models:
The company sells a unique product.
The company sells a unique service.
The company is a low-cost buyer and seller of a product or service that the public has an ongoing need for.
With this basis for selection, Warren looks to choose from the overwhelming number of potential investments in the global marketplace. However, the underlying goal is to find a company with a durable competitive advantage. That is, Warren tries to find the company with a business model that not only meets one of the above three criteria, but also shows a history of consistent success.
The Income Statement
While there are several metrics that can be used to evaluate an income statement, the following ratios and comparisons are key to Warren. It is important to note that though broad generalizations can be helpful in initial analysis, the following list does not suggest a one-size-fits-all model and it should therefore be adapted to each individual industry.
Gross Profit Margin - Dividing a company’s Gross Profit (Revenue minus the Cost of Goods Sold) by its Revenue gives you the Gross Profit Margin. Warren believes to be a key determinant of company success. In reviewing this portion of the income statement, Warren looks for companies that show consistent growth and at least a Gross Profit Margin of 40% (though this can vary between industries).
Selling, General and Administrative (SGA) - In the case of SGA Expenses, Warren looks for companies that spend as little as possible. As a general rule, companies with SGA Expenses within 30-80% of their Gross Profit typically show some form of competitive advantage and therefore a chance for sustainable success. However, as with the Gross Profit Margin, companies will need to show a consistent history of low SGA Expenses as a percentage of Gross Profit.
Research and Development (R&D) - As with SGA Expenses, Warren looks for companies with low R&D Expenses, but for different reasons. In this case, Warren has discovered that companies...