Philippine Christian University

College of Business Administration and Accountancy

Investments and Portfolio Management

LESSON TOPIC: CAPITAL MARKET INVESTMENT DECISIONS

Warren Buffett's Investing Strategy: An Inside Look

(What Is Warren Buffett's Investment Style?)

Source Investorpedia
By ANDREW BLOOMENTHAL
 Updated Feb 8, 2020

A staunch believer in the value-based investing model, investment guru Warren Buffett has long
held the belief that people should only buy stocks in companies that exhibit solid fundamentals,
strong earnings power, and the potential for continued growth. Although these seem like simple
concepts, detecting them is not always easy. Fortunately, Buffet has developed a list of tenets
that help him employ his investment philosophy to maximum effect.

KEY TAKEAWAYS

 Warren Buffett is noted for introducing the value investing philosophy to the masses,
advocating investing in companies that show robust earnings and long-term growth
potential.
 To granularly drill down on his analysis, Buffett has identified several core tenets, in the
categories of business, management, financial measures, and value.
 Buffett favors companies that distribute dividend earnings to shareholders and is drawn to
transparent companies that cop to their mistakes.

Buffett’s tenets (*) fall into the following four categories:

1. Business
2. Management
3. Financial measures
4. Value
(*) Tenet = theory, belief, philosophy, view, ideology, doctrine
This article explores the different concepts housed within each silo.
(Click on all words / topics in blue e.g.. Warren Buffett to get meaning / overview / further information
on such subject)

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 Philippine Christian University
College of Business Administration and Accountancy

Investments and Portfolio Management

Business Tenets
Buffett restricts his investments to businesses he can easily analyze. After all, if a company's
operational philosophy is ambiguous, it's difficult to reliably project its performance. For this
reason, Buffett did not suffer significant losses during the dot-com bubble burst of the early
2000s due to the fact that most technology plays were new and unproven, causing Buffett to
avoid these stocks. (*) Unless you are in speculation mode so invest only what you can afford to lose)

Management Tenets
1. Buffett's management tenets help him evaluate the track records of a company’s higher-
ups, to determine if they've historically reinvested profits back into the company, or if
they've redistributed funds to back shareholders in the form of dividends.
2. Buffett favors the latter scenario, which suggests a company is eager to maximize
shareholder value, as opposed to greedily pocketing all profits.
3. Buffett also places high importance on transparency. After all, every company makes
mistakes, but only those that disclose their errors are worthy of a shareholder’s trust.
4. Lastly, Buffett seeks out companies who make innovative strategic decisions, rather than
copycatting another company’s tactics.

Tenets in Financial Measures

1. In the financial measures silo, Buffett focuses on low-levered companies with
high profit margins. But above all, he prizes the importance of the economic
value added (EVA) calculation, which estimates a company’s profits, after the
shareholders’ stake is removed from the equation. In other words, EVA is the net
profit, minus the expenditures involved with raising the initial capital.

On first glance, calculating the EVA metric is complex, because it potentially

factors in more than 160 adjustments. But in practice, only a few adjustments are
typically made, depending on the individual company and the sector in which it
operates.

Economic Value Added=NOPAT−(CI×WACC)
where:
NOPAT=net operating profit after taxes
CI=capital invested
WACC=weighted average cost of capital

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 Philippine Christian University
College of Business Administration and Accountancy

Investments and Portfolio Management

Buffett's final two financial tenets are theoretically similar to the EVA.

2. He studies what he refers to as "owner's earnings." This is essentially the cash

flow available to shareholders, technically known as free cash flow-to-equity
(FCFE). Buffett defines this metric as net income plus depreciation, minus
any capital expenditures (CAPX) and working capital (W/C) costs. The owners'
earnings help Buffett evaluate a company’s ability to generate cash for
shareholders.

What s free cash flow-to-equity (FCFE)?

Free cash flow to equity is a measure of how much cash is available to the  equity
shareholders  of a company after all expenses, reinvestment, and debt are paid. FCFE
is a measure of equity capital usage.

The Formula for FCFE Is

FCFE=Cash from operations – Capex + Net debt issued

3. Value Tenets

In this category, Buffett seeks to establish a company's intrinsic value. He

accomplishes this by projecting the future owner's earnings, then discounting
them back to present-day levels.

Valuation:

What Is intrinsic value.?

Intrinsic value is a measure of what an asset is worth. This measure is arrived at by means of an
objective calculation or complex financial model, rather than using the currently trading market price of
that asset.

 In financial analysis, this term is used in conjunction with the work of identifying, as nearly as
possible, the underlying value of a company and its cash flow.
 In Options (incl. Real options) pricing it refers to the difference between the strike price of the
option and the current price of the underlying asset.

Intrinsic Value Explained

Intrinsic value is an umbrella term with useful meanings in several areas. Most often the term implies
the work of a financial analyst who attempts to estimate an asset's intrinsic value through the use of
fundamental and technical analysis.

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 Philippine Christian University
College of Business Administration and Accountancy

Investments and Portfolio Management

There is no universal standard for calculating the intrinsic value of a company, but financial analysts
build valuation models based on aspects of a business that include qualitative, quantitative and
perceptual factors.

Qualitative factors—such as business model, governance, and target markets—are those items specific
to the what the business does. Quantitative factors found in fundamental analysis include financial
ratios and financial statement analysis.

These factors refer to the measures of how well the business performs. Perceptual factors seek to
capture investors perceptions of the relative worth of an asset. These factors are largely accounted for
by means of technical analysis.

Creating an effective mathematical model for weighing these factors is the bread and butter work of a
financial analyst. The analyst must use a variety of assumptions and attempt to reduce subjective
measures as much as possible. In the end, however, any such estimation is at least partly subjective. The
analyst compares the value derived by this model to the asset's current market price to determine
whether the asset is overvalued or undervalued.

Some analysts and investors might place a higher weighting on a corporation's management team while
others might view earnings and revenue as the gold standard. For example, a company might have
steady profits, but the management has violated the law or government regulations, the stock price
would likely decline. By performing an analysis of the company's financials, however, the findings might
show that the company is undervalued.

Typically, investors try to use both qualitative and quantitative to measure the intrinsic value of a
company, but investors should keep in mind that the result is still only an estimate.

KEY TAKEAWAYS

 In financial analysis, intrinsic value is the calculation of an asset's worth based on a financial
model.
 Analysts often use fundamental and technical analysis to account for qualitative, quantitative
and perceptual factors in their models.
 In options trading, intrinsic value is the difference between the current price of an asset and the
strike price of the option.

Furthermore, Buffett generally ignores short-term market moves, focusing instead on long-term

returns. But on rare occasions, Buffett will act on short-term fluctuations, if a tantalizing deal
presents itself. For example, if a company with strong fundamentals suddenly drops in price from
$50 per share to $40 per share, Buffet might acquire a few extra shares at a discount.

Finally, Buffett famously coined the term "moat," which he describes as "something that gives a
company a clear advantage over others and protects it against incursions from the competition."

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 Philippine Christian University
College of Business Administration and Accountancy

Investments and Portfolio Management

 
Buffett realizes that not all investors possess the expertise needed to set his analytical tools in
action (* THAT’S YOU) and advises newer investors to consider low-cost index funds over
individual stocks.

The Bottom Line

Buffett's tenets provide a foundation on which he rests his value investing philosophy. But
applying these tenets can be difficult, given the data that must be cultivated and the metrics that
must be calculated. But those who can successfully employ these analytical tools can invest like
Buffett and watch their portfolios thrive.

READ AND UNDERSTAND: Related Terms (Click on BLUE subject matter)

How Shareholder Value Added Works

Shareholder value added (SVA) is a measure of the operating profits that a company has
produced in excess of its funding costs, or cost of capital.
 more

Understanding Return on Invested Capital

Return on invested capital (ROIC) is a way to assess a company's efficiency at allocating the
capital under its control to profitable investments.
 more

How to Calculate the Weighted Average Cost of Capital – WACC

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which
each category of capital is proportionately weighted.
 more

Net Operating Profit Less Adjusted Taxes (NOPLAT)

Net Operating Profit Less Adjusted Taxes (NOPLAT) is a financial metric that calculates a
firm's operating profits after adjusting for taxes.
 more

Enterprise Value – EV
Enterprise value (EV) is a measure of a company's total value, often used as a comprehensive
alternative to equity market capitalization. EV includes in its calculation the market
capitalization of a company but also short-term and long-term debt as well as any cash on the
company's balance sheet.
 more

Cash Value Added (CVA)

Cash value added is a measure of a company's ability to generate cash flow in excess of
investors' required cash flow return on investments.
 more

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 Philippine Christian University
College of Business Administration and Accountancy

Investments and Portfolio Management

Related Articles (Optional reading)

MICROECONOMICS
What to Know About Economic Value Added (EVA)

WARREN BUFFETT
Warren Buffett's Bear Market Maneuvers

TOOLS FOR FUNDAMENTAL ANALYSIS

Free Cash Flow Yield: The Best Fundamental Indicator

WARREN BUFFETT
How Does Warren Buffett Choose His Stocks?

WARREN BUFFETT
Buffett Vs. Soros: Investment Strategies

WARREN BUFFETT
How Does Warren Buffett Plan to Bequeath His Estate?

End of Document

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