Team Shark

Analysis of The Warren Buffett Way

February 11, 2007

Throughout The Warren Buffett Way, many measurements, numbers, and ratios are used

in evaluating a business. When evaluating the business, it is important to remember

management is also taken into consideration along with these figures. The following are

what we have determined to be the most important.

Return on Equity (pg. 110)

When evaluating annual performance, Buffett states that return on equity is

important to look at. He believes that it is a more important measurement than earnings

per share. This measurement is defined as the ratio of operating earnings to shareholders’

equity or total equity, which is found on the balance sheet. However, Buffett does not

use the ROE stated in the financial statements; he tells us that several adjustments should

be made to this ratio to make it more accurate. The first adjustment he suggests is that

securities should be valued at their purchase price rather than their current market price

when determining shareholders’ equity. The second adjustment that is recommended is to

remove all capital gains and losses, and any extraordinary items when figuring operating

earnings.

This measurement is important to Buffett because it demonstrates management’s

ability to generate above-average returns with the amount of capital employed. Since

ROE is the product of profit margin on sales, total asset turnover, interest burden, tax

burden and financial leverage, Buffett looks favorably on high ratios in all of these,

except having high financial leverage. He does not like high financial leverage because it

implies a lot of debt. To Buffett, good quality companies should be able to produce

enough cash without using much debt. Somewhat comparable to ROE, he does not like
earnings per share in this instance because the numbers can be manipulated by

accounting to reflect higher values.

Owners’ Earnings (pg. 113-114)

Owners’ earnings is an important measurement tool to Buffett since it is a key

measurement in evaluating a company’s intrinsic value. To find the intrinsic value of a

company, one must project a series of cash flows for a company out into the future and

then discount them back to a present value. But, the important part is that there are

different cash flow interpretations people can use. Buffett uses what he calls owners’

earnings instead of just the overall cash flow value off the cash flow statement. Buffett’s

owners’ earnings not only equal the company’s net income plus depreciation, depletion,

and amortization, but it also includes a subtraction of capital expenditures and working

capital.

Buffett takes into account capital expenditures because he believes it should be

expensed as an everyday item like labor and utility costs. If it isn’t, the profitability of

the company would decrease due to the long term deferment of expenses. The only bad

part of including capital expenditures is how they are very hard to predict. Nevertheless,

Buffett clearly states how a prediction in this category is better than not including one at

all.

Intrinsic Value (pg. 13-15, 122-130)

Though owners’ earnings is very important, it is just a component in finding a

company’s overall value, or rather what Buffett calls its intrinsic value. While there are
many strategies in going about finding a company’s intrinsic value, such as high dividend

yields, low price/book values, and low price/earnings ratios, Buffett prefers to use the

dividend discount model popularized by John Burr Williams. As stated above, this is a

method of discounting owners’ earnings to the present using a derived discount rate. He

likes this because it incorporates a company’s ability to produce cash along with using a

risk measure associated with a company.

This measurement of intrinsic value is what goes into Buffett and Graham’s

whole concept of having a “margin of safety”, as talked about many times in the book.

Essentially, Buffett’s intrinsic value is what the company is truly worth at this moment,

which can be compared to the company’s net current asset value or also to its current

market value. The difference between the two is what Buffett calls his “margin of safety”

(15). To be safe, the intrinsic value must be significantly less than the current asset value

or market value. Therefore, if Buffett’s concept proves true, he is essentially buying all

of his companies at a discount. So, if you buy something at a discount, it allows for a bit

more of a decrease in the stock price before he feels he is actually losing money in the

company.

It is important to also know how Buffett figures his discount rate in the model.

Typically, a required rate of return is used, which is a combination of the risk-free rate

along with some sort of risk premium associated with the company. However, Buffett

uses only a risk-free rate, specifically the 30-year U.S. government bond rate. The reason

he does not use a risk premium is twofold. The first reason is because a risk premium is

something which is extremely hard to determine. Secondly, he feels that by his analysis
of a company, looking particularly for consistent cash flows and low debt, he is

eliminating much of the risk premium.

Profit Margins (pg. 114-117)

Another tool Buffett uses to analyze a business is to look at its operating profit

margin which is a ratio of EBIT/Sales. Both of these measurements can easily be found

on the income statement. EBIT sometimes is listed as operating income on the

statements.

The core tidbit of wisdom Buffett extracts from profit margins is a company’s

ability to control costs associated with a business. High profit margins are indicative of a

management team capable of cutting costs effectively. To Buffett, cutting costs are a

good way to shield a company from interest rate changes because they are limiting their

amount of fixed assets they hold.

Buffett expresses that he has little patience for managers who allow costs to spiral

out of control. He is quoted as saying that “the really good manager does not wake up in

the morning and say, ‘This is the day I’m going to cut costs,’ anymore than he wakes up

and decides to practice breathing.” (115) Thus, he is saying that cutting costs should not

be an intermittent idea, but rather, a continuous daily practice.

Retained Earnings to Value Created (Pg. 81-106, 117-119)

Our last key tenant Buffett looks at when analyzing a company is management’s

philosophy when it comes to the one-dollar-premise, or how a company uses its retained

earnings to create value. Essentially, the one-dollar-premise means that for every dollar
of retained earnings, at least one dollar of market value should be realized. A way to

measure past results in this category would be to take the dollar amount of retained

earnings for the year in question and compare it to the dollar amount change in market

value (stock price x shares outstanding) for the subsequent year. Buffett reiterates many

times in the book that money should be reinvested only if it can contribute to above

average returns, otherwise it should be either paid out to the shareholders in the form of

dividends or buybacks.

He also talks about the institutional imperative which occurs on a daily basis in

the market. This has to do with management’s ability to make rational decisions

concerning reinvesting in the business despite what other competitors are doing at the

time. Essentially, he wants the companies he is investing in to think completely

independently and rationally. To Buffett, some examples of irrational behavior

resulting from the institutional imperative would include resisting change and needless

projects which foolishly soak up available funds.

Ranking by Importance

1. Return on Equity
2. Intrinsic Value
3. Retained Earnings
4. Profit Margins
5. Owner’s Earnings

For us, Return on Equity was the most important measure for evaluating an

investment. We believe this because ROE, presented with all of its broken-down

components, gives us an overall view of the company’s profitability. The profit margin

tells us a company’s ability to produce sales at the lowest costs. Asset turnover
determines the ability of management to quickly sell its inventory. Interest burden gives

us the relationship between net income and interest paid. Tax Burden portrays the

percentage of income which is left over after taxes. Lastly, financial leverage shows how

much a company relies on debt to produce profits. This makes it so that changes in

returns can be explained with some type of reasoning.

We found it tough choosing between return on equity and intrinsic value because

intrinsic value is an integral part of determining our success from investing in a company

and when the right time to purchase it is, but not necessarily how good or profitable a

company is. However, it would probably be the first thing Buffett would look at, seeing

as how he wouldn’t even purchase a company if he couldn’t buy it at a discount.