3 Key Criteria Warren Buffett Looks For In His Investments

Warren Buffett’s track record makes him one of the investing community’s all-time greats. From 1965 to 2016, he generated an incredible annual return of 19%. In Buffett’s 1989 letter to his shareholders, he shared his key considerations when evaluating a company as an acquisition opportunity.

Given his accomplishments, it would be useful for any investor to learn from Buffett. (Since Buffett looks at stocks as a piece of a business, stock market investors can still benefit from understanding how Buffett thinks through whole acquisitions.) There are six criteria in Buffett’s checklist.

In previous articles, I’ve looked at the first and second criteria. They can be found here and here. In this article, let’s study the third criterion:

“Businesses earning good returns on equity while employing little or no debt”

The third criteria has two parts to it. Let’s start with the first part: Businesses earning good returns on equity.

The return on equity, or ROE, is defined as the amount of income generated by a company, expressed as a percentage of its shareholders’ equity. A higher ratio means a company is earning better returns with its shareholders’ equity. For example, a company with a ROE of 15% is making 15 cents in profit for every dollar of shareholders’ equity it has.

The ROE is an important metric to analyse for us as investors because it shows the ability of a company’s management to reinvest the profits earned by the company. A company’s profit is added to its shareholders’ equity unless it is paid out as a dividend. As such, a company that can maintain a high ROE shows that management is very capable of reinvesting the profits earned.

Let’s now tackle the second part of the third criterion: Little or no debt. The use of debt is a double-edged sword. During good times, debt can help us earn better returns equity by allowing for leverage. But, when the bad times inevitably roll along, the presence of high levels of debt can be the reason why a company goes bankrupt. To reduce risk as an investor, companies with little debt are better options. In good times, they may earn a lower return on equity, but there’s a lot less to worry about during bad times.

The two points in Buffett’s third criterion highlighted above are important for any investor to consider when they are looking for investment opportunities. You can even use it to analyse your current holdings to see if they can pass Buffett’s criterion.

If you enjoyed this, stay tuned for more on Buffett’s acquisition criteria in the coming weeks! [Editor’s note: Articles on Buffett’s fourth, fifth, and sixth criteria have been published. They can be found herehere, and here.]

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