How to identify value stocks the Warren Buffett way?

Warren Buffett is seen as a role model by most investors in the world who wants to emulate classical value investing style. He does his stock picking on a rational basis and avoids any sort of fear and hype in the market to identify value stocks. In most cases, he is seen to take contrarian approach since he is often selling when others are buying and vice versa. To learn how to evaluate a stock, join the NSE Academy Certified Equity Research Analysis course on Elearnmarkets.

There’s a famous quote by Warren Buffet on contrarion approach-

“Be fearful when others are greedy and be greedy when others are fearful”

But how do you find value stocks and how you value a stock? The market value is quite obvious which is the current market price of a stock on any given day. But what about its intrinsic value or the real worth of the company.

Though finding out the intrinsic value is a real challenge but if you can master stock price valuation, you can really become rich. This is what most value investors look for while they do their stock picking . Simply by comparing the intrinsic value with its stock price, you may accordingly take bullish or bearish decision as the case may be.

Here are some of the powerful tools using which Warren Buffet pick value stocks:

1. Return on Equity (ROE)

Warren Buffett often uses Return on Equity (ROE) as part of his investment decision making process. He cares about a company that uses his money wisely and efficiently.  ROE doesn’t care about the stock price rather it suggests that the company is able to utilize its money wisely.

Return on Equity (ROE), which is net income/owner’s equity. This is defined as how efficiently a business is using its equity to generate profits or how much profit a company generates with the money shareholders has invested. Right from the start, it makes sense to use this as an important measure for a stock buying decision because it shows how much management values its company.

ROE also needs to be compared to businesses in the same industry to provide useful information to a potential investor. So for example, ROE for Bank of Baroda should be compared to ROE of PNB. ROE is one measurement commonly used to decide if an investment is worth purchasing. But of course, it should not be the only one. As a matter of fact, it can be artificially increased as well if a company buys back shares of its stock or increases debt. This is a reason why some say ROE could be misleading if you just take it at face value.

2. Return on Asset (ROA)

Return on Assets (ROA) is a type of return on investment (ROI) that measures the profitability of a business in relation to its total assets. This ratio indicates how well a company is performing by comparing the profit it’s generating from the money invested in assets.  The higher the return, the more productive and efficient management is in utilizing economic resources.

Though Buffet focuses on return on equity but as we have seen that it may be distorted by leverage or share buyback, hence it is theoretically inferior to some degree to Return on Asset. Warren Buffett also understands the same of course but instead examines leverage separately, preferring low-leverage companies. Moreover he also looks for high profit margins.

3. Return on Capital Employed (ROCE)

Return on capital employed or ROCE is a profitability ratio that measures how efficiently a company can generate profits from its capital employed by comparing net operating profit to capital employed. In other words, return on capital employed shows investors how many rupees in profits each rupee of capital employed generates.

ROCE is a long-term profitability ratio because it shows how effectively assets are performing while taking into consideration long-term financing. This is why ROCE is a more useful ratio than return on equity to evaluate the longevity of a company.

The return on capital employed (ROCE) is a better measurement tool than return on equity, because ROCE shows how well a company is using both its equity and debt to generate a return.

4. Debt to equity ratio

The company with a low debt-to-equity ratio is conservatively financed, another Buffett parameter in finding value stocks. This is another easy equation: Simply divide the company’s total liabilities by stockholders’ equity. Debt-to-equity ratios can vary by industry, but since we are playing it safe like Buffett, look for debt-to-equity ratios below 1.

High ratios can mean a company has been financing its growth with debt, which is not usually a sustainable practice as it can lead to volatile or uncertain earnings, high interest rate charges or even bankruptcy.

Read: Top 5 investing lessons from Warren Buffett’s shareholders letters 2016

Bottomline

Just as Warren Buffett has said multiple times, stock picking with “predictable and proven” earnings can be very profitable in stock market investing where investors are rewarded with consistent business growth. Moreover, permanent loss of capital can also be largely avoided in this method of stock picking.

Buying undervalued predictable companies is even better and this strategy can greatly outperform the market averages. Apart from the above discussed powerful tools, Buffet also focuses on circle of competence, presence of moats, invest in good management, keep a long term mindset, taking a contrarian play during touch time, etc..