Warren Buffett didn't become the world's fourth richest person by accident — he is one of the most strategic and calculated investors of our time, with a long-term investment strategy that has been described as the "Rip Van Winkle approach." Buffett always invests in companies with good long-term prospects, staying away from technology, start-ups and any flash-in-the-pan bets. (The Oracle of Omaha also stays away from mutual funds, because he believes that over-diversification can hamper returns. Instead, he makes significant investments in just a handful of companies.)
What Warren Buffett Looks for in Investments
Buffett's investments are, well, pretty boring. He favors companies that offer basic services and products: razors, laundry detergent, soft drinks, auto insurance. He subscribes to the Benjamin Graham school of value investing: Look for securities that are undervalued based on their intrinsic worth — because, though intrinsic worth is difficult to measure, it's the best way is to analyze a company's fundamentals.
Fundamentals are what contribute to the financial valuation of a company, security or currency. For a business, that means revenue, earnings, assets, liabilities and growth. To find this, you'd have to look at a company's balance sheet, income statements and cash flow to determine its health and growth prospects. If the company carries little debt and has a lot of cash, those are strong fundamentals.
"The trick to investing is to buy good businesses."
Buffett reportedly says this when people ask for his investing advice; of course, this kind of dictum can lead to more questions: How do you know if the business is good? How do you even know where to look? The answer is, in many ways: It's just as easy as Buffett says it is.
5 Tips for Investing Like Warren Buffett
1. Do Your Research
According to CNBC, Warren Buffett reads five newspapers a day, but let's not forget he also has a team of economists and analysts under his wing, as well as companies offering him premium stocks in hopes he will invest (we should all be so lucky!).
Start with quarterly reports, familiarize yourself with the language of business and become proficient at reading financial statements. According to Buffett, "Accounting is a language all its own and getting comfortable in a foreign language takes a little experience, a little study early on, but it pays off big later."
2. Figure Out What You Know
This is a basic principle of Buffett's investment strategy. Good companies are in an industry you understand, selling products and services that people love, have long-term value and are fairly priced. Finding out what you know is easy — here's how you do it.
3. Do the Math
- Return on equity: Buffett prefers this metric over earnings per share because return on equity measures management's ability to create shareholder value. The math is simple: Divide the net income by shareholder equity — that equals return on equity. Run the numbers on a few competitors; the winning number should come in over 15 percent.
- Debt-to-equity ratio: A company with a low debt-to-equity ratio is conservatively financed, another Buffett parameter. This is another easy equation: Simply divide the company's total liabilities by stockholders' equity. Debt-to-equity ratios can vary by industry, but since we are playing it safe like Buffett, look for debt-to-equity ratios below 1. High ratios can mean a company has been financing its growth with debt, which is not usually a sustainable practice — it can lead to volatile or uncertain earnings, high interest rate charges or even bankruptcy.
- Price-to-book ratio: Buffett does not like to pay a premium for anything, including stock prices. He has famously said, "Whether we are talking about socks or stocks, I like buying quality merchandise when it is marked down." A simple way to find out if a stock is priced is low is to calculate the price-to-book ratio. The P/B ratio is calculated by dividing the current closing stock price by the company's total assets expressed on its balance sheet. A lower P/B ratio might indicate a stock is undervalued or it can mean the company is earning a very poor return on its assets, which is why the return on equity number you calculated earlier is so important.
- Forward price-to-earnings ratio: The forward price-to-earnings ratio is used to compare current earnings to potential future ones, but it's just an estimate and should not be considered reliable data – its merely a forecasting exercise. To calculate the forward P/E, divide the market price per share by the expected earnings per share. If earnings are expected to grow, the ratio will be low. The lower the forward P/E ratio, the better the value.
4. Start Small and Sit Tight
Once you have determined which company you want to invest in, open a brokerage account with a low minimum. Start with a small number of stocks until you get more confident. Don't overthink this — perfect timing is impossible to predict. Many investors make the mistake of trying to time their purchases or obsess over moving their investments around to get better returns. Rapidly trading in and out of stocks can be profitable in the short-term but you will lose long-term returns because turnover increases the taxes paid on capital gains and commission dollars.
5. Ignore Both Optimists and Pessimists
Ignore the negative Nellies — there will always be negativity in the marketplace and people insisting an economic downturn is just around the corner. Ignore the eternal optimists, too — the people who swear things are only going up from here. Focus your efforts on finding a good company you know that is undervalued by the market. Don't worry about the highs and the lows — you're in this for the long haul. If you've done your research you should trust yourself and the investment. After all, remember this famous piece of Buffett advice: "As long as you know the company you're investing in, the better it is for a buyer. Down days always make me feel good."
This article originally appeared on GoBankingRates.com.