Buffet Masterclass (Investing in stocks): 2 - Measuring business financials

Before investing in a business that you judge to have favourable prospects, you must assess whether its true, or intrinsic, value promises you a large enough return on your capital in the longer term. To be sure of your assessment, take Buffett's advice and thoroughly investigate the financial standing of the business before making any decision to buy.

Your self-confidence should be increased by Buffett's insistence that sophisticated financial knowledge is not required. The definition of intrinsic value does rest on a mathematical concept - and there are technicalities involved. Putting them on one side, the basic proposition is simple: compare your proposed stock-market investment, which carries an element of risk, with a risk-free alternative.

The argument is as follows:

* A top-rated government bond is as near to a risk-free investment as you will ever find.

* If the annual interest is 9 per cent, its return over 100 years is 900 per cent of a purchase price of 100.

* Unless the shares in an organization can beat this return, they are plainly not worth buying.

So Buffett looks for companies where the net cash coming into the business can be expected to grow, to all intents and purposes for ever, at a percentage appreciably above the interest on long-term government bonds. The difference between these two future streams of money determines the present-day "intrinsic value" of the shares and, therefore, whether they are worth buying.

Predicting future profits

Buffett always does these calculations before investing. You will see that they rest on prediction, which is always a dodgy business. But you must also turn your favourable view of the company's prospects into hard numbers. What are you actually hoping for, and how realistic is that hope? Buffett's concept carries a powerful lesson you dare not ignore:

Finding the figures

Some of the figures that you need to assess a company's financial prospects must be dug out of the published accounts. Buffett seeks the answers to four critical questions:

Earnings to equity ratio

The first question is the easiest to answer; many companies publish the figure. Equity is the company's capital minus its long-term debt. Divide that into the profits after tax to find the percentage return. This must be significantly higher than the return on long-term bonds. As a rule-of-thumb, a company with a 15 per cent return on equity can be expected to grow its value by 15 per cent per annum.

Shareholder earnings

Working out "owner-earnings" means adding to after-tax profits the funds set aside for financial reasons - above all, depreciation. While the company must allow for the eventual replacement of its plant and equipment, etc., the cash is not being spent now. Adding back depreciation, plus the company's share of any profits from interests in other companies, gives you a truer picture of its earning power.

Profit margins

To answer the third question, you need to measure the strength of the company's "franchise" (its customer base) and its business model (in other words, the relationship between its costs and its prices). Look at operating profits as a percentage of sales. Analyze the results carefully; too low a figure (under 5 per cent) is a discouraging sign, while too high a figure (over 20 per cent) could be unsustainable.

Market value

The fourth question is absolutely vital to your overall assessment of the fundamental value of the business. Add back the "retained" profits that were not paid out in tax and dividends over, say, three years. Compare the company's market value at the start of the period with that at the end. Does the difference add up to more than the retained profits? That is the only way in which management can demonstrate its ability to use shareholders' money wisely and well.

Exercising caution

You are of necessity relying on published accounts. Buffett warns that these often contain misleading figures, sometimes deliberately so. Look carefully at the cashflow. If it is heading down when the profit is going up, be very wary. Remember that a company's accounts will nearly always juggle profits upwards rather than downwards. That being the case, discouraging answers to the four key questions are even more worrying than they seem at first sight.

Buying below market value

There is another rule-of-thumb that will help you to evaluate a business. In the case of Mrs. Blumkin and the Nebraska Furniture Mart, Buffett bought a successful business with capable management for substantially less than the value of its annual sales. Unless there is a sinister explanation, a low ratio of market value to sales is an encouraging sign.

Misleading figures

You cannot bank the profits shown in the accounts. You can only bank the cash coming in. If that is less than the cash going out, bankruptcy may result.

Rolls-Royce, Britain's most famous company, announced decent profits year after year, despite heavy spending on aero-engine research and development. The spending, however, was not charged in the accounts against profits, but added to them as "the value of R&D recoverable from sales resulting from existing orders".

The company still had to find the cash to pay for all the R&D. Re-examination of the accounts showed that the cashflow was negative, and Rolls-Royce could only pay the dividend by raising money from the shareholders!

Eventually, the company ran out of cash and just went bankrupt.