Todd Combs, the CEO of GEICO – a Berkshire Hathaway insurance subsidiary – once outlined what Warren Buffett looks for in investment opportunities. There are three conditions.
One is a forward price-to-earnings (P/E) ratio below 15, another is a 90% chance of making more money five years from now, and a third is a 50% chance of growing at 7% per year. That’s it.
A low price
A forward P/E ratio below 15 is relatively easy to identify. A good illustration of why this is important comes from looking at a stock like Microsoft (NASDAQ:MSFT).
Over the last five years, Microsoft’s grown its earnings per share at 18% a year. That’s hugely impressive and the company seems highly likely to be making more in 2029 than it does today.
The trouble is, the stock trades at a forward P/E ratio of 26, implying an earnings yield of 3.85%. That means the business needs to grow to generate a good return for shareholders.
If Microsoft keeps growing at 18% a year, the earnings yield will be 27.18% over the next five years. But a stock trading at a P/E ratio of 15 with no growth will have a yield of 33%.
That’s why a low P/E’s so important. It ensures a decent earnings yield from the outset, meaning the investment return doesn’t depend on waiting for future growth.
Better in future
Sometimes, stocks trade at low P/E multiples due to unusual short-term opportunities. Croda International’s (LSE:CRDA) a good example of this.
Back in 2021, the stock was trading at around 15 times forward earnings. But those earnings were boosted by extreme demand for Covid-19 vaccines, which the firm provided chemicals for.
When this died down, the company’s earnings fell away sharply. While the stock traded at a forward P/E multiple below 15 in 2021, it wouldn’t have been a good investment.
This is what Buffett’s second condition’s designed to filter out. The aim is to find businesses that have a durable competitive advantage, rather than ones enjoying a short-term surge in demand.
Croda has this to some extent – its patents provide it with durable protection. But it’s important to know when this means a company will make more money in the future and when it doesn’t.
7% growth
Buffett’s 7% growth condition only requires a 50% probability. That’s because a durable business at a P/E multiple of 15 can be a decent investment.
Despite this, the difference between a business that can grow and one that can’t becomes significant over time. And this matters for investors with a long-term outlook.
A P/E multiple of 15 implies a 6.6% earnings yield at the outset. If this grows by 3% annually, the implied return in year 10 is 9.2% of the original investment.
That’s not bad, but if the company’s earnings grow by 7%, the earnings in year 10 represent a 13.25% return. And the gap only gets wider over time.
This is why Buffett prefers buying shares in a great business at a decent price than shares in a decent business at a great price. Over the long term, growth potential’s important.
The post 3 simple things Warren Buffett looks for in stocks to buy appeared first on The Motley Fool UK.
Pound coins for sale — 31 pence?
This seems ridiculous, but we almost never see shares looking this cheap. Yet this Share Advisor pick has a price/book ratio of 0.31. In plain English, this means that investors effectively get in on a business that holds £1 of assets for every 31p they invest!
Of course, this is the stock market where money is always at risk — these valuations can change and there are no guarantees. But some risks are a LOT more interesting than others, and at The Motley Fool we believe this company is amongst them.
What’s more, it currently boasts a stellar dividend yield of around 10%, and right now it’s possible for investors to jump aboard at near-historic lows. Want to get the name for yourself?
See the full investment case
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Stephen Wright has positions in Berkshire Hathaway. The Motley Fool UK has recommended Croda International Plc and Microsoft. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
