Finding Stocks the Warren Buffett Way
by John Bajkowski

Like most successful stockpickers, Warren Buffett thinks that the efficient market theory is 
absolute rubbish. Buffett has backed up his beliefs with a successful track record through 
Berkshire Hathaway, his publicly traded holding company.

Maria Crawford Scott examined Warren Buffett's approach in the January 1998 issue of the AAII 
Journal. Table 1 below provides a summary of Buffett's investment style. In this article, we 
develop a screen to identify promising businesses and then use valuation models to measure 
the attractiveness of stocks passing the preliminary screen. 

Buffett has never expounded extensively on his investment approach, although it can be 
gleaned from his writings in the Berkshire Hathaway annual reports. Many books by outsiders 
have attempted to explain Buffett's investment approach. One recently published book that 
discusses his approach in an interesting and methodical fashion is "Buffettology: The Previously 
Unexplained Techniques That Have Made Warren Buffett the World's Most Famous Investor," by 
Mary Buffett, a former daughter-in-law of Buffett's, and David Clark, a family friend and 
portfolio manager [published by Simon & Schuster, 800-223-2336; $27.00]. This book was used 
as the basis for this article.

Monopolies vs. Commodities 
Warren Buffett seeks first to identify an excellent business and then to acquire the firm if the 
price is right. Buffett is a buy-and-hold investor who prefers to hold the stock ofa good 
company earning 15% year after year over jumping from investment to investment with the 
hope of a quick 25% gain. Once a good company is identified and purchased at an attractive 
price, it is held for the long-term until the business loses its attractiveness or until a more 
attractive alternative investment becomes available.

Buffett seeks businesses whose product or service will be in constant and growing demand. In 
his view, businesses can be divided into two basic types: 

Commodity-based firms, selling products where price is the single most important factor 
determining purchase. Buffett avoids commodity-based firms. They are characterized with high 
levels of competition in which the low-cost producer wins because of the freedom to establish 
prices. Management is key for the long-term success of these types of firms. 

Consumer monopolies, selling products where there is no effective competitor, either due to a 
patent or brand name or similar intangible that makes the product or service unique. 

While Buffett is considered a value investor, he passes up the stocks of commodity-based firms 
even if they can be purchased at a price below the intrinsic value of the firm. An enterprise 
with poor inherent economics often remains that way. The stock of a mediocre business treads 
water. 

How do you spot a commodity-based company? Buffett looks for these characteristics:
     The firm has low profit margins (net income divided by sales); 
     The firm has low return on equity (earnings per share divided by book value per share); 
     Absence of any brand-name loyalty for its products; 
     The presence of multiple producers; 
     The existence of substantial excess capacity; 

     Profits tend to be erratic; and 
     The firm's profitability depends upon management's ability to optimize the use of tangible assets.

Buffett seeks out consumer monopolies. These are companies that have managed to create a 
product or service that is somehow unique and difficult to reproduce by competitors, either 
due to brand-name loyalty, a particular niche that only a limited number companies can enter, 
or an unregulated but legal monopoly such as a patent.

Consumer monopolies can be businesses that sell products or services. Buffett reveals three 
types of monopolies: 

Businesses that make products that wear out fast or are used up quickly and have brand-name 
appeal that merchants must carry to attract customers. Nike is a good example of a firm with a 
strong brand name demanded by customers. Any store selling athletic shoes must carry Nike 
products to remain competitive. Other examples include leading newspapers, drug companies 
with patents, and popular brand-name restaurants such as McDonald's. 

Communications firms that provide a repetitive service that manufacturers must use to 
persuade the public to buy the manufacturer's products. All businesses must advertise their 
items, and many of the available media face little competition. These include worldwide 
advertising agencies, magazine publishers, newspapers, and telecommunications networks. 

Businesses that provide repetitive consumer services that people and businesses are in constant 
need of. Examples include tax preparers, insurance companies, and investment firms. 

Mary Buffett suggests going to your local 7-Eleven or White Hen Pantry to identify many of 
these "must-have" products. These stores typically carry a very limited line of must-have 
products such as Marlboro cigarettes and Wrigley's gum. However, with the guidance of the 
factors used to identify attractive companies, we can establish a basic screen to identify 
potential investments worthy of further analysis. 

The rules used for our Buffett screen are identified and discussed in Table 2. AAII's Stock 
Investor Professional was used to perform the screen. Consumer monopolies typically have high 
profit margins because of their unique niche; however, a simple screen for high margins may 
highlight weak firms in industries with traditionally high margins, but low turnover levels.

Our first screening filters looked for firms with both gross operating and net profit margins 
above the median for their industry. The operating margin concerns itself with the costs 
directly associated with production of the goods and services, while the net margin takes all of 
the company activities and actions into account. 

Understand How It Works 
As is common with successful investors, Buffett only invests in companies he can understand. 
Individuals should try to invest in areas where they possess some specialized knowledge and 
can more effectively judge a company, its industry, and its competitive environment. While it 
is difficult to construct a quantitative filter, an investor should be able to identify areas of 
interest. An investor should only consider analyzing those firms operating in areas that they can 
clearly grasp. 

Conservative Financing

Consumer monopolies tend to have strong cash flows, with little need for long-term debt. 
Buffett does not object to the use of debt for a good purpose--for example, if a company uses 
debt to finance the purchase of another consumer monopoly. However, he does object if the 
added debt is used in a way that will produce mediocre results--such as expanding into a 
commodity line of business. 

Appropriate levels of debt vary from industry to industry, so it is best to construct a relative 
filter against industry norms. We screened out firms that had higher levels of total liabilities to 
total assets than their industry median. The ratio of total liabilities to total assets is more 
encompassing than just looking at ratios based upon long-term debt such as the debt-equity 
ratio. 

Strong & Improving Earnings
Buffett invests only in a business whose future earnings are predictable to a high degree of 
certainty. Companies with predictable earnings have good business economics and produce 
cash that can be reinvested or paid out to shareholders. Earnings levels are critical in 
valuation. As earnings increase, the stock price will eventually reflect this growth. 

Buffett looks for strong long-term growth as well as an indication of an upward trend. In the 
book, Mary Buffett looks at both the 10- and five-year growth rates. Stock Investor Professional 
contains only seven years of data, so we examined the seven-year growth rate as the long-term 
growth rate and the three-year growth rate for the intermediate-term growth rate. 

For our screen, we first required that a company's seven-year earnings growth rate be higher 
than that of 75% of the stocks in the overall database. Stock Investor Professional includes 
percentile ranks for growth rates, so we specified a percentile rank greater than 75. 

It is best if the earnings also show an upward trend. Buffett compares the intermediate-term 
growth rate to the long-term growth rate and looks for an expanding level. For our next filter, 
we required that the three-year growth rate in earnings be greater than the seven-year growth 
rate. This further reduced the number of passing companies to 213. Not surprisingly, the 
companies passing the Buffett screen have very high growth rates--as a group, nearly three 
times the median for the whole database. 

Consumer monopolies should show both strong and consistent earnings. Wild swings in earnings 
are characteristic of commodity businesses. A examination of year-by-year earnings should be 
performed as part of the valuation. The earnings per share for Nike are displayed in the Buffett 
valuation spreadsheet. Note that earnings per share growth has been strong and consistent with 
only one year in which earnings did not increase from the previous period. 

A screen requiring an increase in earnings for each of the last seven years would be too 
stringent and not be in keeping with the Buffett philosophy. However, a filter requiring positive 
earnings for each of the last seven years should help to eliminate some of the commodity-
based businesses with wild earnings swings.

A Consistent Focus
Companies that stray too far from their base of operation often end up in trouble. Peter Lynch 
also avoided profitable companies diversifying into other areas. Lynch termed these 
diworseifications. Quaker Oats' purchase and subsequent sale of Snapple is a good example of 
this common mistake. 

Companies should expand into related areas that offer high return potential. Nike's past 
development of a line of athletic clothing to complement its athletic shoe business is an 
example of a extension that makes sense. This factor is clearly a qualitative screen that cannot 
be done with the computer. 

Buyback of Shares 
Buffett views share repurchases favorably since they cause per share earnings increases for 
those who don't sell, resulting in an increase in the stock's market price. This is a difficult 
variable to screen as most data services do not indicate this variable. You can screen for a 
decreasing number of outstanding shares, but this factor is best analyzed during the valuation 
process. 

Investing Retained Earnings 
A company should retain its earnings if its rate of return on its investment is higher than the 
investor could earn on his own. Dividends should only be paid if they would be better employed 
in other companies. If the earnings are properly reinvested in the company, earnings should 
rise over time and stock price valuation will also rise to reflect the increasing value of the 
business. 

An important factor in the desire to reinvest earnings is that the earnings are not subject to 
personal income taxes unless they are paid out in the form of dividends. The use of retained 
earnings delays personal income taxes until the stock is sold. 

Buffett examines management's use of retained earnings, looking for management that have 
proven it is able to employ retained earnings in the new moneymaking ventures, or for stock 
buybacks when they offer a greater return. 

Good Return on Equity 
Buffett seeks companies with above average return on equity. Mary Buffett indicates that the 
average return on equity over the last 30 years has been around 12%. 

We created a custom field that averaged the return on equity for the last seven years to 
provide a better indication of the normal profitability for the company. During the valuation 
process, this average should be checked against more current figures to assure that the past is 
still indicative of the future direction of the company. Our screen looks for average return on 
equity of 12% or greater. 

Inflation Adjustments 
Consumer monopolies can typically adjust their prices quickly to inflation without significant 
reductions in unit sales since there is little price competition to keep prices in check. This 
factor is best applied through a qualitative examination of a company during the valuation 
stage.

Reinvesting Capital 
In Buffett's view, the real value of consumer monopolies is in their intangibles--for instance, 
brand-name loyalty, regulatory licenses, and patents. They do not have to rely heavily on 
investments in land, plant, and equipment, and often produce products that are low tech. 
Therefore they tend to have large free cash flows (operating cash flow less dividends and 
capital expenditures) and low debt. Retained earnings must first go toward maintaining current 
operations at competitive levels. This is a factor that is also best examined at the time of the 
company valuation although a screen for relative levels of free cash flow might help to confirm 

a company's status. 

The above basic questions help to indicate whether the company is potentially a consumer 
monopoly and worthy of further analysis. However, stocks passing the screens
are not automatic buys. The next test revolves around the issue of value. 

The Price is Right
(Using the Spreadsheet)
The price that you pay for a stock determines the rate of return--the higher the initial price, 
the lower the overall return. The lower the initial price paid, the higher the return. Buffett 
first picks the business, and then lets the price of the company determine when to purchase 
the firm. The goal is to buy an excellent business at a price that makes business sense. 
Valuation equates a company's stock price to a relative benchmark. A $500 dollar per share 
stock may be cheap, while a $2 per share stock may be expensive.

Buffett uses a number of different methods to evaluate share price. Three techniques are 
highlighted in the book with specific examples and are used in the buffet spreadsheet 
template.

Buffett prefers to concentrate his investments in a few strong companies that are priced well. 
He feels that diversification is performed by investors to protect themselves from their 
stupidity. 

Earnings Yield
Buffett treats earnings per share as the return on his investment, much like how a business 
owner views these types of profits. Buffett likes to compute the earnings yield (earnings per 
share divided by share price) because it presents a rate of return that can be compared quickly 
to other investments. 

Buffett goes as far as to view stocks as bonds with variable yields, and their yields equate to 
the firm's underlying earnings. The analysis is completely dependent upon the predictability 
and stability of the earnings, which explains the emphasis on earnings strength within the 
preliminary screens. 

Nike has an earnings yield of 5.7% (cell C13, computed by dividing earnings per share of $2.77 
(cell C9) by the price $48.25 (cell C8)). Buffett likes to compare the company earnings yield to 
the long-term government bond yield. An earnings yield near the government bond yield is 
considered attractive. With government bonds yielding around 6% currently (cell C17), Nike 
compares very favorably. By paying $48 dollars per share for Nike, an investor gets an earnings 
yield return equal to the interest yield on bonds. The bond interest is cash in hand but it is 
static, while the earnings of Nike should grow over time and push the stock price up.

Historical Earnings Growth 
Another approach Buffett uses is to project the annual compound rate of return based on 
historical earnings per share increases. For example, earnings per share at Nike have increased 
at a compound annual growth rate of 18.9% over the last seven years (cell B32). If earnings per 
share increase for the next 10 years at this same growth rate of 18.9%, earnings per share in 
year 10 will be $15.58. [$2.77 x ((1 + 0.189)^10)]. (Note this value is found in cells B49 and 
E39) This estimated earnings per share figure can then be multiplied by the average price-
earnings ratio of 14.0 (cell H10) to provide an estimate of price [$15.58 x 14.0=$217.43]. (Note 
this value is found in cell E42) If dividends are paid, an estimate of the amount of dividends 

paid over the 10-year period should also be added to the year 10 price [$217.43 + $13.29 = 
$230.72]. (Note this value is found in cell E43) 

Once this future price is estimated, projected rates of return can be determined over the 10-
year period based on the current selling price of the stock. Buffett requires a
return of at least 15%. For Nike, comparing the projected total gain of $230.72 to the current 
price of $48.25 leads projected rate of return of 16.9% [($230.72/$48.25) ^
(1/10) - 1]. (Note this value is found in cell E45)

Sustainable Growth
The third approach detailed in "Buffettology" is based upon the sustainable growth rate model. 
Buffett uses the average rate of return on equity and average retention ratio (1 average payout 
ratio) to calculate the sustainable growth rate [ ROE x ( 1 - payout ratio)]. The sustainable 
growth rate is used to calculate the book value per share in year 10 [BVPS ((1 + sustainable 
growth rate )^10)]. Earnings per share can be estimated in year 10 by multiplying the average 
return on equity by the projected book value per share [ROE x BVPS]. To estimate the future 
price, you multiply the earnings by the average price-earnings ratio [EPS x P/E]. If dividends 
are paid, they can be added to the projected price to compute the total gain.

For example, Nike's sustainable growth rate is 19.2% [22.8% x (1 - 0.159)].(Sustainable growth 
rate is found in cell H11) Thus, book value per share should grow at this rate to roughly $65.94 
in 10 years [$11.38 x ((1 + 0.192)^10)]. (Note this value is found in cell B64) If return on equity 
remains 22.8% (cell H6) in the tenth year, earnings per share that year would be $15.06 [ 0.228 
x $65.94]. (Note this value is found in cell E54) The estimated earnings per share can then be 
multiplied by the average price-earnings ratio to project the price of $210.23 [$15.06 x 14.0]. 
(Note this value is located in cell E56) Since dividends are paid, use an estimate of the amount 
of dividends paid over the 10-year period to project the rate of return of 16.5% [(($210.23 + 
$12.72)/ $48.25) ^ (1/10) - 1]. (Note this return estimate is found in cell E60)

Conclusion
The Warren Buffett approach to investing makes use of "folly and discipline": the discipline of 
the investor to identify excellent businesses and wait for the folly of the market to buy these 
businesses at attractive prices. Most investors have little trouble understanding Buffett's 
philosophy. The approach encompasses many widely held investment principles. Its successful 
implementation is dependent upon the dedication of the investor to learn and follow the 
principles. 

John Bajkowski is editor of Computerized Investing and senior financial analyst of AAII.
(c) Computerized Investing - January/February 1998, Volume XVII, No.1

Table 1. The Warren Buffett Approach

Philosophy and style 
Investment in stocks based on their intrinsic value, where value is measured by the ability to 
generate earnings and dividends over the years. Buffett targets successful businesses--those 
with expanding intrinsic values, which he seeks to buy at a price that makes economic sense, 
defined as earning an annual rate of return of at least 15% for at least five or 10 years. 

Universe of stocks 

No limitation on stock size, but analysis requires that the company has been in existence for a 
considerable period of time. 

Criteria for initial consideration
Consumer monopolies, selling products in which there is no effective competitor, either due to 
a patent or brand name or similar intangible that makes the product unique. In addition, he 
prefers companies that are in businesses that are relatively easy to understand and analyze, 
and that have the ability to adjust their prices for inflation. 

Other factors 
       A strong upward trend in earnings 
       Conservative financing 
       A consistently high return on shareholder's equity 
       A high level of retained earnings 
       Low level of spending needed to maintain current operations 
       Profitable use of retained earnings 

Valuing a Stock 
Buffett uses several approaches, including: 

Determining firm's initial rate of return and its value relative to government bonds: Earnings 
per share for the year divided by the long-term government bond interest rate. The resulting 
figure is the relative value-the price that would result in an initial return equal to the return 
paid on government bonds.

Projecting an annual compounding rate of return based on historical earnings per share 
increases: Current earnings per share figure and the average growth in earnings per share over 
the past 10 years are used to determine the earnings per share in year 10; this figure is then 
multiplied by the average high and low price-earnings ratios for the stock over the past 10 
years to provide an estimated price range in year 10. If dividends are paid, an estimate of the 
amount of dividends paid over the 10-year period should also be added to the year 10 prices

Stock monitoring and when to sell 
Does not favor diversification; prefers investment in a small number of companies that an 
investor can know and understand extensively. Favors holding for the long term as long as the 
company remains "excellent"--it is consistently growing and has quality management that 
operates for the benefit of shareholders. Sell if those circumstances change, or if an 
alternative investment offers a better return. 

Table 2. Translating the Buffett Style Into Screening

Questions to determine the attractiveness of the business: 

Consumer monopoly or commodity? 
Buffett seeks out consumer monopolies selling products in which there is no effective 
competitor, either due to a patent or brand name or similar intangible that makes the product 
unique. Investors can seek these companies by identifying the manufacturers of products that 
seem indispensable. Consumer monopolies typically have high profit margins because of their 

unique niche; however, simple screens for high margins may simply highlight firms within 
industries with traditionally high margins. For our screen, we looked for companies with 
operating margins and net profit margins above their industry norms. Additional screens for 
strong earnings and high return on equity will also help to identify consumer monopolies. 
Follow-up examinations should include a detailed study of the firm's position in the industry 
and how it might change over time.

Do you understand how it works?
Buffett only invests in industries that he can grasp. While you cannot screen for this factor, you 
should only further analyze the companies passing all screening criteria that operate in areas 
you understand. 

Is the company conservatively financed?
Buffett seeks out companies with conservative financing. Consumer monopolies tend to have 
strong cash flows, with little need for long-term debt. We screened for companies with total 
liabilities below the median for their respective industry. Alternative screens might look for 
low debt to capitalization or to equity. 

Are earnings strong and do they show an upward trend?
Buffett looks for companies with strong, consistent, and expanding earnings. We screened for 
companies with seven-year earnings per share growth greater than 75% of all firms. To help 
indicate that earnings growth is still strong, we also required that the three-year earnings 
growth rate be higher than the seven-year growth rate. Buffett seeks out firms with consistent 
earnings. Follow-up examinations should include careful examination of the year-by-year 
earnings per share figures. As a simple screen to exclude companies with more volatile 
earnings, we screened for companies with positive earnings for each of the last seven years and 
latest 12 months. 

Does the company stick with what it knows?
A company should invest capital only in those businesses within its area of expertise. This is a 
difficult factor to screen for on a quantitative level. Before investing in a company, look at the 
company's past pattern of acquisitions and new directions. They should fit within the primary 
range of operation for the firm. 

Has the company been buying back its shares?
Buffett prefers that firms reinvest their earnings within the company, provided that profitable 
opportunities exist. When companies have excess cash flow, Buffett favors shareholder-
enhancing maneuvers such as share buybacks. While we did not screen for this factor, a follow-
up examination of a company would reveal if it has a share buyback plan in place. 

Have retained earnings been invested well?
Earnings should rise as the level of retained earnings increase from profitable operations. Other 
screens for strong and consistent earnings and strong return on equity help to the capture this 
factor. 

Is the company's return on equity above average? 
Buffett considers it a positive sign when a company is able to earn above-average returns on 
equity. Marry Buffett indicates that the average return on equity for over the last 30 years is 
approximately 12%. We created a custom field that calculated the average return on equity 
over the last seven years. We then filtered for companies with average return on equity above 
12%. 

Is the company free to adjust prices to inflation? 
True consumer monopolies are able to adjust prices to inflation without the risk of losing 
significant unit sales. This factor is best applied through a qualitative examination of the 
companies and industries passing all the screens. 

Does company need to constantly reinvest in capital? 
Retained earnings must first go toward maintaining current operations at competitive levels, so 
the lower the amount needed to maintain current operations, the better. This factor is best 
applied through a qualitative examination of the company and its industry. However, a screen 
for high relative levels of free cash flow may also help to capture this factor. 

Buffett Valuation Worksheet (January/February 1998, Computerized Investing, www.aaii.com)

See Buffet Valuation Spread Sheet for Valuation of Stocks