Five Questions One Must Ask Himself Before Investing In Stock

Here, let’s take a look at how Warren Buffett finds value in stocks by asking himself some questions when evaluating the relationship between a stock’s level of excellence and its price.

                 

The first question to be asked is, whether the company has consistently performed well. Buffett always looks at the Return on Equity (ROE) to see whether or not a company has consistently performed well in comparison to other companies in the same industry. Note that looking at the ROE for only the past year isn't enough. Investors should consider the ROE for the past 5-10 years to get a good idea of the company’s historical performance.

Secondly, check whether the company has avoided excess debt. Buffett prefers to see a small amount of debt, so that the earnings growth is being generated from shareholders’ equity as opposed to borrowed money.

The third factor to look at is whether the profit margins are too high and whether they are increasing. The profitability of a company depends not only on having a good profit margin, but also on consistently increasing this margin. To get a good indication of the company’s historical profit margins, investors should look back into its records for at least a 5-year period.

The fourth factor is how long the company has 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 onto Buffett's radar. Further, he states that one should never underestimate the value of historical performance as it demonstrates the company’s ability (or inability) to increase shareholder value.

The fifth factor is whether the company’s products rely on a commodity. It is likely that you think of this question as a radical approach to narrowing down on a company. However, Buffett sees this question as an important one. He tends to shy away (though not always) from companies whose products are indistinguishable from those of their competitors. If the company does not offer anything different from what is offered by another firm within the same industry, there is little that sets the company apart.

Last but not the least is whether the stock is selling at a 25 per cent discount to its real value. This is the clincher. Finding companies that meet the other five criteria is one thing, but determining whether or not they are undervalued is the most difficult part of value investing and Buffett’s most important skill.

Sounds easy, doesn’t it? Of course, Buffett's success 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 in calculating value. If we try to follow the first 5 factors, we may be able to avoid some bad investments.