When it comes to making an investment in a company, there is one thing Warren Buffett of Berkshire Hathaway (BRK.A 0.45%) (BRK.B 0.01%) always looks to -- and it likely isn't what you think.
One vital number
With earnings season in full swing, most investors will look to the top-line revenue number or bottom-line income to gauge how well or poorly the company did.
After all, almost all coverage of announcements will include some note about how well the earnings per share did relative to "analyst's estimates" to give some indication of the strength of the quarter.
And while those numbers are important to watch, there is one thing Buffett always looks to when he considers an investment or acquisition. And that is the company's ability to generate healthy, consistent, and predictable cash flows.
In his own words:
Our acquisition preferences run toward businesses that generate cash, not those that consume it [...] however attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash.
Buffett undeniably comes from the Benjamin Graham school of value investing. So often people believe ideology only accounts for price to earnings and other similar valuation ratios, but Buffett almost throws all of those out the window, noting:
Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.
Consider for a moment Warren Buffett's second largest investment, Coca-Cola (KO 1.58%). If Buffett has held onto his 400 million shares -- which is an easy thing to assume considering he's said he'll "never sell," a share -- the market value of his Coca-Cola position would stand at $15.8 billion. Yet among the biggest companies, Coca-Cola isn't necessarily a compelling consideration from a traditional "value perspective" that focuses on P/E ratios.
A quick glance at the price-to-earnings ratio shows that Coca-Cola at 20.4 trades higher than both PepsiCo (19.3) and Dr Pepper Snapple Group (15.7). Coke's stock has looked "expensive" at times, but the business' ability to generate cash has kept Buffett from officially cashing in on his massive profits.
Yet, when you consider the growth in its cash flow over the years, Coke has continually been growing its ability to generate cash year after year:
While Buffett's investment consideration of course goes beyond one simple number or metric, the purported value of a company is not simply a multiple of what it says it earns compared to its current price. Instead, investors need to see how those earnings translate to cash generation and the company's overall ability to return that cash to shareholders when making an investment consideration.
Although Coke may not pique the interest of many because of its valuation, it turns out when it comes to cash flow generation -- what Buffett will "run toward" -- it is indeed among the best. Whether its Coke, Procter & Gamble, or ExxonMobil, all three fit Buffett's bill and will likely be in the Berkshire portfolio for a long, long time.