Warren Buffett is known for his disciplined and thoughtful approach to evaluating companies before investing in them. He uses several key financial metrics to assess a company’s profitability, sustainability, and overall health. These metrics help Buffett determine if a company has a strong competitive advantage, is profitable even during economic downturns, and has favorable financial policies. Let’s take a closer look at each of these 14 key metrics and understand why they matter to Buffett.
1. Gross Margin
Formula: Gross Margin = Gross Profit / Revenue
Buffett expects a gross margin consistently above 40%. This indicates that a company has pricing power, meaning it can set prices high enough to cover its costs and still generate a significant profit. High gross margins suggest that customers are willing to pay a premium for its products or services, and it can fend off price competition.
2. Profit Margin
Formula: Profit Margin = Net Income / Revenue
A profit margin above 20% shows that a company can sustainably generate healthy profits. If a company consistently achieves this, it implies that the business model is strong and the company has a competitive advantage that protects it from competitors, allowing it to keep prices high or costs low.
3. Earnings Per Share (EPS)
Formula: EPS = Net Income / Shares Outstanding
Buffett values companies that maintain positive and growing EPS, especially during economic downturns. This metric reflects how much profit is allocated to each share of stock, showing if the company is capable of sustainable growth even when times are tough.
4. Retained Earnings Growth
Retained earnings represent the cumulative net income that a company has earned and retained since its inception. Buffett looks for companies that consistently grow their retained earnings, as this shows that the company has generated more profit than it has spent. A company that grows retained earnings during downturns is even more impressive, as it suggests resilience and a strong business model.
5. Capital Expenditure (CapEx)
CapEx is the money spent on long-term investments, such as property or equipment. Buffett prefers companies where CapEx is less than 25% of net income. This is important because large capital expenditures reduce free cash flow, making it harder for the company to reinvest in growth or pay dividends to shareholders.
6. Sales, General & Administrative (SG&A) Expenses
Formula: SG&A / Gross Profit
Buffett prefers companies where SG&A expenses are consistently under 30% of gross profit. This metric shows how much the company needs to spend on operations to generate sales. Keeping SG&A expenses low suggests that the company can efficiently generate sales without overspending on overhead or marketing.
7. Research & Development (R&D) Margin
Formula: R&D Margin = R&D Expenses / Gross Profit
Buffett likes companies where R&D expenses are under 30% of gross profit. This metric indicates that the company doesn’t have to spend a significant portion of its revenue on developing new products. While R&D is important for innovation, high R&D costs can hurt profitability if they don’t lead to profitable new products.
8. Depreciation Margin
Formula: Depreciation Margin = Depreciation / Gross Profit
Buffett prefers depreciation to be under 10% of gross profit, which suggests that the company is not capital-intensive. A business with lower depreciation expenses is often more efficient and doesn’t require constant reinvestment in physical assets like machinery or equipment.
9. Interest Expense Margin
Formula: Interest Expense Margin = Interest Expense / Operating Income
Buffett prefers companies with an interest expense margin under 15%, which means that the company hasn’t taken on too much debt. A company with manageable interest expenses can better weather downturns without the risk of financial distress due to high debt payments.
10. Income Tax Margin
Formula: Income Tax Margin = Income Tax / Pre-tax Income
Buffett expects a company’s tax margin to align with the current corporate tax rate (21% in the U.S.). This indicates that the company is not using aggressive accounting methods to lower its tax bill, which shows transparency and honesty in management. If a company is truthful in its tax practices, it is more likely to be trustworthy with shareholders.
11. Cash & Debt
Buffett believes that a company’s cash and investments should exceed its debt. Having more cash than debt makes a company more resilient during economic downturns. With more cash, a company can buy back shares, invest in competitors, or offer lower prices, which strengthens its position in tough times. Conversely, too much debt can lead to financial instability.
12. Adjusted Debt to Equity
Formula: Adjusted Debt to Equity = Total Liabilities / (Shareholder Equity – Treasury Stock)
Buffett looks for a debt-to-equity ratio below 0.80. This indicates that the company is largely financed by equity rather than debt, reducing the risk of financial trouble. A lower ratio means that the company doesn’t rely too much on borrowed money, which can be a burden during tough times.
13. Preferred Stock
Buffett avoids companies that issue preferred stock. Companies that use preferred stock are often struggling to raise capital or need special arrangements to attract investors. Strong companies should not need to offer preferred stock to raise money.
14. Treasury Stock
Treasury stock refers to the company’s repurchased shares. Buffett prefers companies that have done share buybacks, as this can signal confidence in the business. Repurchasing shares reduces the number of outstanding shares, boosting earnings per share and increasing the value of remaining shares.
Through these metrics, Warren Buffett seeks to uncover whether a company has a durable competitive advantage, can remain profitable during downturns, and has favorable financial policies. He looks for businesses that don’t require massive spending to grow, can self-finance, and are transparent with shareholders. This disciplined approach allows Buffett to identify companies that are likely to thrive in the long run, even during challenging economic conditions.
How to Apply these Principles to your Investments
To apply Warren Buffett’s key metrics to your own trades, start by evaluating a company’s gross margin. You want to see a margin consistently above 40%, as this shows the company has pricing power and can generate significant profits without being undercut by competitors. Following this, check the profit margin. A profit margin above 20% signals that the company can sustainably generate healthy profits and fend off competition, which is crucial for long-term growth.
Next, focus on the company’s earnings per share (EPS). Buffett emphasizes the importance of positive and growing EPS, especially during economic downturns. This shows that the business is capable of maintaining its growth even in difficult times. Alongside EPS, you should look at the growth of retained earnings. A company that consistently grows its retained earnings, even during recessions, is likely generating more profit than it spends, indicating strong financial health.
Capital expenditure (CapEx) is another critical factor. If CapEx is less than 25% of net income, the company isn’t overspending on maintaining operations, preserving more cash for growth and other initiatives. Additionally, consider the efficiency of the company’s operations by evaluating its sales, general, and administrative (SG&A) expenses. A company with SG&A expenses under 30% of gross profit is managing its costs well, making it more efficient.
Another key area to check is the research and development (R&D) margin. A lower R&D margin (under 30%) means the company doesn’t need to invest heavily in new products to stay competitive. Likewise, keep an eye on depreciation margin. If depreciation is under 10% of gross profit, the company isn’t overly reliant on capital-intensive assets, which can drain resources.
Debt management is also important. Look for companies where interest expenses are less than 15% of operating income, as this shows they haven’t taken on excessive debt. Similarly, a reasonable income tax margin, close to the corporate tax rate (around 21%), suggests transparency and honest management, which should inspire confidence in shareholders.
Cash and debt levels are critical indicators of resilience. A company with more cash than debt is in a better position to weather tough times and seize growth opportunities, such as buying back shares or acquiring competitors. Additionally, a debt-to-equity ratio below 0.80 indicates that the company relies more on equity financing than debt, reducing financial risk.
Buffett avoids companies that issue preferred stock, as strong companies don’t need it to raise capital. Finally, it’s a good sign if a company has bought back its own shares. Share buybacks indicate management’s confidence in the business and can increase the value of remaining shares.
By applying these metrics, you can assess whether a company has a competitive advantage, is financially sound, and can maintain profitability even during downturns. This approach will help you make more informed and strategic trading decisions, following Buffett’s principles of investing in fundamentally strong businesses.
Disclaimer
Every effort has been made to ensure the accuracy of the information provided, but no liability will be accepted for any loss or inconvenience caused by errors or omissions. The information and opinions presented are offered in good faith and based on sources considered reliable; however, no guarantees are made regarding their accuracy, completeness, or correctness. The author and publisher bear no responsibility for any losses or expenses arising from investment decisions made by the reader.
