Warren Buffett attracts a lot of attention. As the world's third-richest person and most celebrated investor, thousands try to glean what they can from his thinking processes and track his investments.

While we can't know for sure whether Buffett is about to buy E*TRADE (Nasdaq: ETFC) -- he hasn't specifically mentioned anything about it to me -- he's left us some clues as to whether it's the sort of stock that might interest him. Answering that question could also inform whether it's an idea that should interest us.

In his most recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size and a reasonable valuation, he demands:

  1. Consistent earnings power.
  2. Good returns on equity with limited or no debt.
  3. Management in place.
  4. Simple, non-techno mumbo jumbo businesses.

Does E*TRADE meet Buffett's standards?

1. Earnings power
Buffett is famous for betting on sure things. For that reason, he likes to see companies with demonstrated earnings stability.

Let's examine E*TRADE's earnings and free cash flow history:



Source: Capital IQ, a division of Standard & Poor's. Free cash flow is adjusted based on author's calculations.

E*TRADE has had wobbly earnings over the past few years, largely because of writedowns on its mortgage-backed securities.

2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt burden, because that will skew your calculations and make the company look much more efficient than it actually is.

Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context:

Company

Debt-to-Equity Ratio

Return on Equity (LTM)

Return on Equity
(5-Year Average)

E*TRADE

272%

(26%)

(16%)

Charles Schwab (Nasdaq: SCHW)

22%

11%

22%

TD AMERITRADE (Nasdaq: AMTD)

34%

18%

28%

optionsXpress

0%

19%

42%

Interactive Brokers (Nasdaq: IBKR)

298%

3%

20%

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months.

E*TRADE has had a difficult time generating high returns on equity; the last year it was above 15% was in 2006. It also has substantial debt.

3. Management
E*TRADE's CEO, Steve Freiberg, has only been at the job since April. Before that, he worked at Citigroup for several decades.

4. Business
Technology in the discount brokerage business evolves somewhat quickly; it's unclear whether Buffett would feel comfortable with the industry.

The Foolish conclusion
Whether or not Buffett would ever invest in E*TRADE, we've learned that the company doesn't exhibit the characteristics of a quintessential Buffett investment: consistent earnings power, long-tenured management, and high returns on equity with low debt.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Ilan Moscovitz doesn't own shares of any company mentioned. Interactive Brokers Group, optionsXpress Holdings, and Charles Schwab are Motley Fool Stock Advisor selections. The Fool owns shares of Interactive Brokers Group. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.