Warren Buffett, known in the financial world as the “Oracle of Omaha”, has reached the summit of business excellence and has become the most judicious financial investor and is admired the world over. Warren Buffett is an investor’s icon with a magnificent ability to select companies that will yield great profit year after year.
Through Warren Buffett’s case study, we can see many financial principles. His principles aren´t very complex and you probably don´t have to be a mathematical or a social science genius to understand them. But in order to apply them you need a very conservative, clear and analytical character. Some few of those are following:
Economic reality, accounting reality: Buffett devotes most of his attention not to tracking share price but to analyzing the economics of the underlying business and assessing its management. He was the fundamental analyst of the business (Bruner, Eades & Schill, 2010).
Time value of money or value creation: Is the company cheap on a valuation level? This is the part of the Buffett magic that is hard to quantify because it deals with a company’s intrinsic value. That’s the value that goes beyond its liquidation value and includes all the many intangibles that are hard to put a figure on, such as the worth of a brand name. In general, Buffet will want to purchase a company that is available at a 25% discount to its intrinsic value (Christ, 2008). Measure the performance by gain value creation and long term investment:
Buffett’s tool in measure the performance is return on equity or ROE. Buffett uses ROE as a measure of company has consistently performed over time vs. its peers (Christ, 2008). Warren Buffett is a long-term investor, which means he doesn’t buy for a quick buck but rather long-term returns.
To quote Buffett, he has “an entrance strategy and not an exit strategy”. Buffett seeks to acquire great companies trading at a discount to their intrinsic value, and to hold them for a long time. Regarding the types of businesses Berkshire likes to purchase, Buffett stated, “We want businesses to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.” Risk and discount rates
His attitude is risk of loss first. Buffett says that he looks at the worst case scenario at any time before investing. Therefore, he makes sure to know what his potential losses are. This is also why he keeps 20G$ in liquidity in Berkshire (Mike, 2010). He doesn’t make much on this cash sitting in the money market but he is sure to avoid depending on anybody else.
This is the kind of guy that will never be caught out by a sudden drop in the economy. Investing behavior should be driven by information, analysis, and self-discipline: Buffett invests only in companies he thoroughly researches and understands. He doesn’t go into an investment prepared to lose. Buffett believes the most important quality for an investor is temperament, not intellect.
A successful investor doesn’t focus on being with or against the crowd. The stock market will swing up and down. But in good times and bad, Buffett stays focused on his goals (Loiacono, 2010). Investment diversification: In his view, investors typically purchased far too many stocks rather than waiting for one exceptional company. Alignment of agents and owners: For four of Berkshire’s directors, over 50% of their family net worth was represented by shares in Berkshire Hathaway. And Buffet keeps well over 99% of his net worth in Berkshire (Bruner, Eades & Schill, 2010).
Through Berkshire Hathaway, Warren Buffett was successful in insurance companies and reinsurance as Geico and General Re that generate substantial capital (Float) derived from insurance premiums. These companies are sources of funds it allocates them to subsidiaries of Berkshire Hathaway and it uses to acquire new businesses. Warren Buffett is the largest shareholder of railroad Burlington Northern Santa Fe (BNSF), which holds 11%. What should the subject have done differently from a financial management standpoint?
The public has always seen in Warren Buffett a different kind of capitalist, an honest observer providing sound financial advice regardless of his personal interests. One of Buffett’s differences is his attitude of risk and discount rates. From financial management standpoint, financial leverage can increase the shareholders’ return on their investment and often there are tax advantages associated with borrowing. Debt financing magnifies changes in operating income into even greater proportionate changes in earnings after taxes. A lot of firms use leverage in order to expand operations.
Buffett thinks different. He, with his attitude of risk and discount rates, frowns upon companies with high levels of debt. His firm used almost no debt financing. He focused on companies with predictable and stable earnings. He prefers that earnings growth is generated by shareholder equity as opposed to borrowed funds. In this case, the higher the ratio becomes, the more debt that a company carries.
And while this figure varies from industry to industry, a good way to measure it would be by looking for a ratio that is less than 80% of the industry average (Christ, 2008). These, of course, are just a few of the many ways that Warren Buffet has built up his massive portfolio over the years. The difference between his own financial principles and financial management standpoints has not only made him wealthy, but has also made him the best brand on the market today. When he speaks, the markets follow. Investing principles that Warren Buffett has used during all these years to become the most prosperous investor of all time.
Bruner R., Eades K. & Schill M. (2010). Case studies in Finance. 6th ed. McGraw-Hill/Irwin. Christ S. (2008). How These 6 Simple Questions Have Made Warren Buffett Wealthy. Retrieved on Oct 6, 2010 from http://www.wealthdaily.com/articles/warren+buffett-investment-principles/1156 Mike M. (2010). 4 Investing Principles From Warren Buffett. Retrieved on Oct 6, 2010 from http://www.greenpandatreehouse.com/2010/08/4-investing-principles-from-warren-buffett/ Loiacono S. (2010). Rules That Warren Buffett Lives By. Retrieved on Oct 6, 2010 from http://financialedge.investopedia.com/financial-edge/0210/Rules-That-Warren-Buffett-Lives-By.aspx