The Simple Formula That Warren Buffett Uses to Pick Stocks


Warren Buffett announced this morning that he is acquiring Heinz, the ketchup maker (HNZ) for $72.50 a share. This should not be a shock to anyone who has followed the stock picks of Buffett for years, as I have, since Buffett loves companies with a certain set of characteristics.

What are the characteristics that Buffett looks for in a stock? a consistently profitable business that is easy to understand with a great brand that generates high returns on capital,and at a price that is less than half of what the company returns on its capital.

Lets look at each factor individually:

1) The Company must have a Great Brand Name, if you have never heard of the brand or ever purchased anything from the company as a consumer, than it is not a great brand name.

2) The Company must be easy to understand and have predictable cash flows and earnings. This is fairly easy to look up as well, all you have to do is look at the cash flow statement and the earnings of the company over the last 10 years, if they are stable and do not fluctuate a lot, that is a business Warren wants to buy.

3) The company must generate a high return on capital. This is the secret tip, Buffett looks at a very simple ratio to derive Return on Capital, he looks at EBIT (which is Earning Before Interest and Taxes which can be found on the Income Statement) and divides this by the company’s total equity (which is the company’s total assets minus its total liabilities, this can be found on the balance sheet. Buffett has said in the past (from articles and speeches) that he would love to buy companies which can consistently return more than 25% on capital a year.

So Buffett’s secret formula is this:
1) The Company must have a strong Brand Name
2) The Company must have a predictable and stable business.
3) The Company must have a high return on capital.
4) The Price for which he is willing to pay for the company must be less than half of the company’s return on capital.(Use Price to Cash Flow or Enterprise Value to EBIT for this)

Obviously in the case of Heinz, all of these criteria were met, everyone has heard of or bought Heinz Ketchup, the Ketchup business is very stable and predictable, further evidenced by the company’s historical cash flow and earnings statements, the company earns a high return on capital (an incredible 36% Return on Capital) and lastly the price, Buffett paid 17 times cash flow which is half of the the company’s Return on Capital (36).

So here is a simple screen that you can use to find stocks that Buffett would invest in, oh and if you can do this successfully you too can return 25% a year on your portfolio as well.

Here is the screen:
1) Screen for stocks with a Market Cap over $2 Billion (These are stocks that are Midcap and above, the larger the market cap the more stable the company usually is and the stronger its brand name is)
2) Screen for stocks with a Return on Capital above 30%
3) Buy only the stocks that have the following: A Brand you have heard of or used, and most importantly a Price to Cash Flow or Enterprise Value to EBIT that is less than half of the stocks Return on Capital.

Lastly remember Buffett is very picky about the stocks he buys so you should never come up with a list of more than 2 or 3 stocks if you are running the screen correctly.

When I ran the screen this morning I came up with only one stocks and that is Bed Bath and Beyond (BBBY).
1) Everyone has heard of or purchased something from Bed Bath and Beyond, so this stock passes the brand name test.
2) The company has a return on capital of 30% with zero debt
3) The company has very stable earnings and cash flow, as the company’s products towels, lines and bath products are virtually recession proof.
4) Most Importantly Bed Bath and Beyond is cheap, it has a Price to Earnings Ratio of 13, a Price to Cash Flow of 14.7 and Enterprise Value to EBIT of only 8 all of which are less than half of the company’s Return on Capital of 30.

I truly believe this is the exact type of company Buffett would buy if he was not handicapped with so much money, and its exactly the type of companies that most Billionaire Investors and Hedge Funds buy as well.

Will Meade
Editor of The Billionaires Portfolio