Yesterday, I looked at how Warren Buffett thinks. Today, we take a look at how he does it. Here are some of his preferred methods:

Return on Equity = Net Income / Shareholder’s Equity. Look at this stat over 10 years for a company. Yes, that does involve a lot of math. You need to understand how this type of investing works and the time it involves.

Debt Equity Ratio = Total liabilities / shareholder’s equity. You want a low number here. A high number indicates the company is financing itself with debt. That means they are more volatile, and interest rate hikes could hurt this company more than a competitor without as much debt.

Profit Margin = Net income / net sales. Is this number high? Is it increasing? That would be a very good sign. These numbers usually only increase when management has firm control over costs while at the same time driving good sales numbers.

Other questions (and Buffett’s preferred answers):
Has the company been around for 10 years or more? (Yes)
Does the company rely heavily on one commodity, such as oil or steel? (No)
Is the stock selling at a 25% discount to real value? (Yes)

This is not set in stone. You can go back and find many great Buffett investments that did not meet this criteria. That said, if you can find a few stocks that meet everything above, you will have a very good chance of seeing nice returns over the next few years.

Technorati Tags: warren, buffett, investing