Buffet Approach of Valuing Stock

2755 Words12 Pages
The Buffett Approach to Valuing Stocks
Focusing on return on capital may be the key to investment success.
By Steven R. Ferraro, CFA, PhD
2009 Volume 12 Issue 3
Much has been written about famed U.S. investor and Berkshire Hathaway CEO Warren Buffett’s investment style and successes. Preeminent among these writings are the oft-cited Berkshire Hathaway shareholder letters, written by the “Oracle of Omaha” himself. These informative letters have been the basis for a multitude of books. But even with an abundance of available information on “how to invest like Warren Buffett,” it is apparent that something is lacking, how does Buffett determine an acceptable price for companies of interest? This article provides an example of the process
…show more content…
To get to that point, we will go through several steps that are explained in great detail in books by Buffett’s former daughter-in-law, Mary Buffett.[6][7] These steps are summarized below, with a few of my own adjustments to make the analysis more robust. We will use Eaton Corporation (ETN) as our sample firm because Buffett invested over $100 million in the diversified power management company in 2008.

click image to view model

Step 1, Gather the raw data and create the basic spreadsheet.
In the accompanying valuation model, the historical accounting data for ETN are found in rows 11 through 19. Rows 11 through 16 contain the variables used by Mary Buffett in her Buffettology books. In columns N and O, the annual and cumulative growth rates for each variable are calculated. The remaining data are used as a sanity check. For example, if EPS growth exceeds that of the revenues and net income, it is likely that management is accelerating EPS growth by repurchasing shares. While ETN’s average annual EPS growth (11.03 percent) outpaces its revenue growth (8.87 percent), it does not exceed the growth rate of the net income (12.25 percent). This means that ETN has been issuing shares over the past 10 years, which is confirmed by noting the cumulative growth rate in shares outstanding (15.06 percent) in cell O14.
Another relationship to keep an eye on is that between revenue growth and net income growth. For ETN, net income has outpaced revenue by

More about Buffet Approach of Valuing Stock

Get Access