Warren Buffett (Trades, Portfolio) is widely considered one of the greatest investors of all time. The CEO of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) has amassed a multibillion-dollar fortune by sticking to a proven investment strategy focused on fundamental analysis.
A key part of Buffett’s approach involves carefully analyzing key financial ratios to identify companies with strong, enduring competitive advantages. As Buffett says, “I do not like debt and do not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.”
So it should not come as a surprise the ratios Buffett focuses on help assess a company’s debt levels, earnings power and overall profitability. By studying these three critical ratios, individual investors can gain insight into how Buffett picks winning stocks.
Debt-to-equity ratio
The debt-to-equity ratio is one of the first metrics Buffett examines when analyzing a company. This ratio compares the total liabilities a company has to total shareholder equity. It shows the proportion of equity and debt a company is using to finance its assets.
Buffett prefers to see a debt-to-equity ratio of under 0.5 for most companies. In other words, he likes to invest in businesses that use less than 50% debt to finance their assets. The lower the ratio, the less leveraged a company is.
A high debt-to-equity ratio indicates the company relies heavily on borrowing to fund growth. This can introduce risks should interest rates rise or earnings falter. Too much debt can choke a company during recessions or downturns in the business cycle. It raises the risk of insolvency and bankruptcy.
By investing in companies with low debt-to-equity ratios, Buffett minimizes risk. He sticks to businesses with sturdy balance sheets that can withstand industry shocks and volatile economic conditions. Avoiding highly leveraged companies is a defensive technique that helps protect capital.
As the saying goes, “All you need is a few good investments in your lifetime.” So Buffett takes his time to find quality companies that are not heavily weighed down by large debt burdens. Reliable earnings and staying power are more important than rapid growth.
The debt-to-equity ratio also gives a glimpse into management’s willingness to take on unnecessary risk. Responsible managers are conservative when it comes to using leverage. Buffett views a low debt ratio as a mark of prudent capital management.
In summary, the debt-to-equity ratio helps identify companies with lower risk, greater flexibility, and more resilient earnings. It’s a quick way to gauge balance sheet strength. While this metric alone doesn't give the full picture, it's a good starting point.
Earnings yield
After assessing debt levels, Buffett digs deeper into a company's profitability. One ratio he stresses is the earnings yield. This metric compares a company's earnings per share to its share price.
Buffett views earnings yield like the return on an investment. It reveals what percentage return a company's earnings represent based on the current share price. The earnings yield helps benchmark potential returns against alternative investments.
Specifically, Buffett likes to compare the earnings yield to long-term government bond yields. An earnings yield that is close to or higher than bond yields is typically seen as attractive. Stocks with high earnings yields have more earnings relative to their share price.
Buffett sees stocks with high earnings yields as undervalued opportunities. The market is underestimating their earnings potential and upside. These tend to be the value stocks Buffett targets.
Conversely, low earnings yields reveal stocks where investors have bid up share prices faster than earnings are growing. Growth stocks often trade at lower earnings yields because investors expect rapid gains to continue.
Ultimately, Buffett uses the earnings yield to estimate the potential long-term return for stocks. He combines the earnings yield with earnings growth assumptions to forecast returns. Favorable earnings yields hint at above-average future returns.
While the earnings yield offers useful insight, it should be used cautiously on some types of companies. For example, earnings yields tend to run higher for financial stocks like banks and insurers. Comparing their yields to non-financials may be misleading. Investors should focus on comparing companies within the same industry when analyzing this ratio.
Return on equity
In addition to studying debt levels and earnings potential, Buffett zooms in on how efficiently a company is generating returns on shareholder capital. This is quantified using the return on equity ratio.
ROE measures net income generated as a percentage of shareholder equity. In essence, it reveals how much profit a company earns based on the shareholders' invested capital. Buffett wants to own businesses with high ROEs, as this shows capable capital allocation.
When analyzing ROE, Buffett looks for a consistently high ratio over the long term. He typically wants to see returns on equity exceeding 8% to 10% over a decade or more. A rising ROE over time is ideal, as this indicates a company is getting more efficient and profitable.
Stocks with low or declining ROEs often have competitive issues or management problems impacting performance. Buffett avoids these businesses. A strong ROE, on the other hand, is a hallmark of companies with economic moats and pricing power. These tend to compound earnings reliably.
Care should be taken when using ROE alone to compare stocks across industries. Capital-intensive sectors like manufacturing tend to have lower ROEs than software firms or consumer businesses. As with other financial metrics, comparisons work best between direct industry peers.
The debt-to-equity myth
While debt-to-equity, earnings yield and ROE form Buffett's ratio trifecta, some other popular metrics fail to make the cut. Take the debt-to-equity ratio, for example. This similar-sounding ratio seems logical to use alongside debt-to-equity for added context on leverage.
However, Buffett avoids the debt-to-equity ratio in his analysis process. This ratio compares total debt to shareholders' equity rather than total liabilities. By only incorporating debt, it leaves out important context on liabilities like accounts payable, accrued expenses and pension obligations.
For a fuller picture of balance sheet leverage, Buffett sticks to the more comprehensive debt-to-equity ratio using total liabilities. Debt-to-equity can produce an artificially low number that masks risks from broader liabilities.
The price-earnings myth
While debt-to-equity, earnings yield, and ROE form Buffett's ratio trifecta, some other popular metrics fail to make the cut. Take the long-term debt-to-equity ratio, for example. This similar-sounding ratio seems logical to use alongside total debt-to-equity for added context on leverage.
However, Buffett avoids the long-term debt-to-equity ratio in his analysis process. This ratio compares total debt to shareholders' equity rather than total liabilities. By only incorporating debt, it leaves out important context on liabilities like accounts payable, accrued expenses, and pension obligations.
For a fuller picture of balance sheet leverage, Buffett sticks to the more comprehensive total debt-to-equity ratio using total liabilities. Long-term Debt-to-equity can produce an artificially low number that masks risks from broader liabilities.
Cut through the noise with Buffett’s three ratios
Buffett's investment strategy proves that focusing on a few key metrics can go a long way. His success is a testament to using fundamental ratios like debt-to-equity, earnings yield and ROE to cut through Wall Street noise.
While no ratio paints the full picture, together, these three assessments help identify financially sound companies with enduring competitive strengths. Avoid overused metrics like the price-earnings and debt-to-equity ratios to stay focused on business fundamentals.
New investors are often eager to start analyzing stocks but do not know where to look with so many ratios to choose from. However, taking a page from Buffett’s playbook and mastering a few core ratios is an excellent starting point. Stick to these three fundamental indicators, and you will be well on your way to making smarter stock picks.
