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It's not surprising that Warren Buffett's investment strategy has reached mythical proportions. But how does he do it? Below are the most important tenets of Buffett's famed investment philosophy.

Buffett's Philosophy

Buffett follows the Benjamin Graham school of value investing. Value investors look for securities with prices that are unjustifiably low based on their intrinsic worth. There isn't a universally accepted way to determine intrinsic worth, but it's most often estimated by analyzing a company's fundamentals. Like bargain hunters, the value investor searches for stocks that he or she believes are undervalued by the market, stocks that are valuable but not recognized by the majority of other buyers.

Buffett takes this value investing approach to another level. Many value investors do not support the efficient market hypothesis, but they do trust that the market will eventually start to favor those quality stocks that were, for a time, undervalued. Buffett, however, isn't concerned with the supply and demand intricacies of the stock market. In fact, he's not really concerned with the activities of the stock market at all. This is the implication in this paraphrase of his famous quote: "In the short term the market is a popularity contest; in the long term it is a weighing machine."

He chooses stocks solely based on their overall potential as a company - he looks at each as a whole. Holding these stocks as a long-term play, Buffett seeks not capital gain but ownership in quality companies extremely capable of generating earnings. When Buffett invests in a company, he isn't concerned with whether the market will eventually recognize its worth. He is concerned with how well that company can make money as a business.

Buffett's Methodology

Here we look at how Buffett finds low-priced value by asking himself some questions when he evaluates the relationship between a stock's level of excellence and its price. Keep in mind that these are not the only things he analyzes but rather a brief summary of what he looks for:

1. Has the company consistently performed well?

Sometimes return on equity (ROE) is referred to as "stockholder's return on investment." It reveals the rate at which shareholders are earning income on their shares. Buffett always looks at ROE to see whether a company has consistently performed well compared to other companies in the same industry. ROE is calculated as follows:

= Net Income / Shareholder's Equity

Looking at the ROE in just the last year isn't enough. The investor should view the ROE from the past five to 10 years to analyze historical performance.

2. Has the company avoided excess debt?

The debt/equity ratio is another key characteristic Buffett considers carefully. Buffett prefers to see a small amount of debt so that earnings growth is being generated from shareholders' equity as opposed to borrowed money. The debt/equity ratio is calculated as follows:

= Total Liabilities / Shareholders' Equity

This ratio shows the proportion of equity and debt the company is using to finance its assets; and the higher the ratio, the more debt - rather than equity - is financing the company. A high debt level compared to equity can result in volatile earnings and large interest expenses. For a more stringent test, investors sometimes use only long-term debt instead of total liabilities in the calculation above.

3. Are profit margins high? Are they increasing?

A company's profitability depends not only on having a good profit margin, but also on consistently increasing it. This margin is calculated by dividing net income by net sales. For a good indication of historical profit margins, investors should look back at least five years. A high profit margin indicates the company is executing its business well, but increasing margins mean management has been extremely efficient and successful at controlling expenses.

4. How long has the company been public?

Buffett typically considers only companies that have been around for at least 10 years. As a result, most of the technology companies that have had their initial public offerings (IPOs) in the past decade wouldn't get on Buffett's radar. He will invest only in a business that he fully understands, and he has said he does not understand the mechanics behind many of today's technology companies. Value investing requires identifying companies that have stood the test of time but are currently undervalued.

Never underestimate the value of historical performance, which demonstrates the company's ability (or inability) to increase shareholder value. Do keep in mind, however, that a stock's past performance does not guarantee future performance. The value investor's job is to determine how well the company can perform as it did in the past. Determining this is inherently tricky. But evidently Buffett is very good at it.

5. Do the company's products rely on a commodity?

Initially you might think of this question as a radical approach to narrowing down a company. Buffett, however, sees this question as an important one. He tends to shy away (but not always) from companies whose products are indistinguishable from those of competitors, and those that rely solely on a commodity such as oil and gas. If the company does not offer anything different than another firm within the same industry, Buffett sees little that sets the company apart. Any characteristic that is hard to replicate is what Buffett calls a company's economic moat, or competitive advantage. The wider the moat, the tougher it is for a competitor to gain market share.

6. Is the stock selling at a 25% discount to its real value?

This is the kicker. Finding companies that meet the other five criteria is one thing, but determining whether they are undervalued is the most difficult part of value investing. And it's Buffett's most important skill. To check this, an investor must determine a company's intrinsic value by analyzing a number of business fundamentals including earnings, revenues and assets. And a company's intrinsic value is usually higher (and more complicated) than its liquidation value, which is what a company would be worth if it were broken up and sold today. The liquidation value doesn't include intangibles such as the value of a brand name, which is not directly stated on the financial statements.

Once Buffett determines the intrinsic value of the company as a whole, he compares it to its current market capitalization - the current total worth (price). If his intrinsic value measurement is at least 25% higher than the company's market capitalization, Buffett sees the company as one that has value. Sounds easy, doesn't it? Well, Buffett's success, however, depends on his unmatched skill in accurately determining this intrinsic value. While we can outline some of his criteria, we have no way of knowing exactly how he gained such precise mastery of calculating value.

Bottom Line

As you have probably noticed, Buffett's investing style is like the shopping style of a bargain hunter. It reflects a practical, down-to-earth attitude. Buffett maintains this attitude in other areas of his life: He doesn't live in a huge house, he doesn't collect cars and he doesn't take a limousine to work. The value-investing style is not without its critics, but whether you support Buffett or not, the proof is in the pudding. He is one of the richest people in the world, with a net worth of $76.8 billion.

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