How to Select Stocks for Long Term Investment according to Warren Buffett

Understand a financial statement of a business

Warren Buffett, the richest investor in the stock market in the world, always says when we invest in share market, it is imperative to understand the underlying business of a particular company before buying shares. Analysis of the financial statements of past years is the way to study the performance of a business. But more than 95% of investors buy and sell shares based on their prices and disregard underlying business activities. Many psychological factors affect such investors since they are ignorant about the reality of the business.Therefore, they fail to stay confident about future performances of the company over a long term.

When we see a financial statement, it has three divisions namely; the balance sheet, the income statement and the cash flow statement.They all show where is money of the business.

Balance sheet shows company’s asserts, liabilities and share holder’s equity. An asset is a product or service that generates money or once sold gives money to the company. For instance, inventory, machines, buildings and cash in hand can be considered as company assets. In contrast, a liability is taking money away from the company as with loans, rents and employee’s payments. The value that we get after the liabilities subtract from the asserts is share holders equity, in other words, net worth or book value of the company. When shareholders equity divide by number of common shares, we get equity per share or book value per share.

In the income statement, we observe data on income and expenses on producing goods and services, taxations, interest payments on their loans and eventually, the net profit. It facilitates us to understand whether the company is making profits or losses. When we divide net profit from number of issued common shares, we get earning per share(EPS).

When we analyse, we calculate ‘return on equity’ that is the result taken by dividing net profit from share holder’s equity. On average, a good performing American company has over 12% ‘return on equity’ (ROE). If we analyse a series of financial statements over the past years, we can see whether the ROE is almost constant or not which is an important observation.Thereafter, we search for whether the company is constantly capable of enhancing the share holders equity. If those two basic criteria are satisfied then we make a decision that company is performing averagely well or even above average.If the price of the business share is agreeable, we may buy those shares.

Value of the business

Next step is valuing the business. Warren Buffett defines a value as what you get in contrast to the price which is what you give. As I describe in detail below, he consider the value of a company after next 10 years and discount it back to present price and compare it with a USA government bond for 10 years term.Then he take 75% of that amount as the value of the company share.

We will take a true example but anonymous.

Company’s percent EPS = Xp=US $3.30

Company’s future (after 10 years) EPS=Xf

number of years considered (n)=10

Return on Equity(ROE) 10 years average =30% per annum

USA government bond rate for 10 years = 4%per annum

Formula for compound rate of return is applied here to detect future EPS.

Xf =Xp(1+0.30)n=10


= US$ 45

If we want to get 45 US$ interest after 10 years from government bonds we have to invest US$ 114 at present.

We argue,In comparison to that investment in bonds, at least 75% of that investment equal to the value of a considered business share. It is US$ 85.

But that particular business share was selling at NYSE-USA at 28 US$ in last Sep 2009.Therefore,according to the decision making method of value investment, it is a good share to buy.

Shall we take a Canadian Bank

(According to Standard & Poor’s data we can analysis)

Average return on equity for last 5 years(2004-2008)=17% per annum

EPSpresent = $ 4.90

EPS10years =$ 4.90(1+17/100)10=$23.55

To earn Canadian $23.55 after 10 years we have to buy a Canadian 10 year Gov.Bond at $78.50 (at a annual interest rate at 3.33%).

75% of that price is $ 59.

You may consider about that bank that perform good even under the prevailing economic situation and decide to buy even slightly above the estimated price.As long as we buy the share below the estimated value we reduce the risk of investing.Warren Buffett is a person who is very careful not to take risks.

We may further consider other indicators such as average price to earning per share, price per book value of a share and price per cash flow and they are facilitating our decision when buying shares.

Warren Buffett further says, that a temporary draw back in a company or the country’s economy result with price bargains. A mass panic psychosis on a lawsuit or rummers of a merger or a war situation can also result with such opportunities.

There are a lot to learn about stock investments but above mention facts are salient basics of proper value investing.

Choose proper mentors

An important advice in the book titled “The richest man in Babylon” wrote by George S Clason is to take advice from a person who involved with it.According to the book,at the beginning of investing, the richest man in Babylon named Arkad, also lost all his money as a result of wrong advices.

Warren Buffett may be the best mentor whom you may follow if you choose to invest in business shares.A incident happened at a annual meeting of Berkshire Hathaway ,which is the company that Warren Bufett own, will explain the way of thinking of Warren Buffet.Somebody asked whether should he sell the stocks that prices have gone up and keep the ones that have not? Warren replied and said ‘No, you look at the value of the business.Then, Charlie Munger, a close business associate of Warren,who was there added,Warren was telling him that the whole conceptual framework is wrong.It teach us the correct pattern of thinking for stock market investments.

Recently, I read an article wrote by David Stanly in ‘Canadian money saver Sep 2009 issue’ on value investing in the stock market and he agreed on value of long term investments in business shares and justify it with his data analysis. He states, even then, it is difficult to find from mass media about trading of stocks, other than ‘Buy and hold is dead’. Most headlines urging investors to switch to market timing. But market timing opens investors to lower returns, increasing costs and high taxes. It also can cause added stress and only one who benefited from your frequent short term trading is your broker.

But it is your duty to listen with care to others. A ‘yarn’ to explain my view is follows A cat has taken to a ‘veterinary’ and said it looks ill. Cat was kept on a table and the Veterinary surgeon yelled at the cat and asked to ‘jump’ then ,as cat stay standstill, he loudly yelled and commanded ‘roll over’ still cat was not responding. Later, he turned towards cat’s owner and said he cannot find any thing wrong with the cat. It teach to us do not listen to people with different interest than us. We all work on mass mentality but we should cultivate contrary approach and take wise decisions to get advantage from the other investors mistakes.

Warren Buffett was very successful as he practice contrary approach in stock market investing.He teach us to look at the business whereas majority of us look at the market prices only. He says diversification is a indication of ignorance about the business.Stock market is not always show us what is happening in the business itself. Most of the investors are unable to estimate long term value of a business and short sighted.

Warren Buffett’s way…

When Warren select a business to invest he give equal attention whether he buys single share or multiple shares or even the total business. He goes through series of selection criteria before make a decision on buying.

Thus,he use all available information about that company for at least past 10 years and go through financial statements and analyse them, and also study the analysed information from a lot of other magazines,web pages, and even visit the company and talk to customers, and the management. Base on all gathered information, he decide whether the company can survive profitably among it’s competitors at least for next 10 years. That is what we known as company’s durable competitive advantage.

He also consider long term debt to annual net income ratio as a indicator of survival of the business under a turbulent economic circumstances which will adversely effect on the competitiveness of the business. He advice the maximum safe level of total long term debts is 5 times of the annual net income.

At a TV interview, Warren Buffett was asked by a journalist what is his important advice to fresh stock market investors. He replied and said a beginner should go through all businesses available in the stock market and study their financial state.Then, the journalist told there are over 2000 businesses and what is his option at that situation? His response was that a beginner should start from the business name ‘A’ and continue onward.

There are a much to learn about stock investments but above mention facts are salient basics of proper value investing which is the way I understood according to the teachings by world’s biggest and successful investor Warren Buffett. Although we have to read and learn a lot about share market investing before investing money in shares, a major part of our education is coming from actual involvement within the share market.It is just like the way we learn to ride a bicycle.