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Thursday, June 11, 2009

How To Invest Like Warren Buffet Part 1

So who's the old dude with all that money? If you do not know who Warren Buffet is yet, then you might want to look near the top of the Forbes top 100 rich list. Warren Buffet is one of the world's most successful investors in the world and at one point in time he boasted a net worth of over 50 billion dollars. Yes that's right, billion, and guess what he still lives in the same house he bought before he attained a majority of this wealth! Talk about humble.

Either way, this guy can take a shower in money at any given point. Today we are going to see how he analyzes a firm, so we to can strive to attain some of his knowledge and wealth.

If you aren't familiar with financial statements, you can normally break them down into the following four sections.
1) Balance Sheet - This is where you can get a picture of firms assets and liabilites

2)Income Statement- The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.

3)Shareholders Equity/Book Value -
Shareholders' equity represents the amount by which a company is financed through common and preferred shares.

4)Cash Flow Statement - is a financial statement that shows how changes in balance sheet and income accounts affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities.

Now in order to figure out if a company is worthy of your hard earned dollars to be invested in, you need to do the following for each of the statements above.

Consistency and Competitive Advantage

When Buffet invests in firms, he usually has two requirements. First, he looks for a firm with a competitive advantage. This usually consists of firms who sell a unique product or service such as Coke or Moody's. Secondly, he looks for firms that are consistent in terms of products, gross margins, money in R&D, growth etc. The firms who are consistent will always have a durable competitive advantage.

The first statement we will look at is the income statement as this will indicate alot of key information right of the bat.

Income Statement

1) Gross profit margin = Gross Profit/Total Revenue
a. Firms should have consistently higher gross margin profits 40% and above.
b. Gross profit margin of 20% and below shows high competition
c. Track the gross profit margin for 10 years to see consistency

2)Selling, administrative and General costs- a. The lower the better. Look for a range of 30-80% of gross profit

3)Research & Development –
a. firms that have to spend a lot on R&D have an inherent flaw in their competitive advantage which puts their long term economics at risk and should be avoided.

a. Always consider depreciation as a real cost, the less the better. Look for a range of 0-12% of gross profit. The higher it is means they have high capital expenditures

5)Interest Expense – Higher interest represents higher debt.
Look for firms that have an expense of less than 15% of operating expenses as their interest.
a. Banks have a higher ratio due to leverage
b. The firm with the lowest interest expense in a given sector has a durable competitive advantage.

6)Net Earnings-
a. Look for a historical upward trend 5-10 yrs (lookout for share repurchases which could affect net earnings and the per share profit)
b. Look at the percentage of net earnings to total revenue. Good firms like coke earn 21% and Moody’s earns 31% on total revenues.
c. Rule of thumb is 20% for firms with a long term durable advantage.

9)Per share earnings-
a. Look for an upward consistent trend for the past 10yrs
b. Avoid erratic EPS on a long term basis, it shows inconsistency

The next statement to be analyzed will be the Balance Sheet and Shareholders equity. Stay Tuned!

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