Learn Why Buffett uses ROE to Invest

This post is sponsored by Seeking Alpha. Each month, Alpha Picks emails investors 2 data-driven stock picks to hold long-term. Click here to receive $50 off your first year subscription.

Most investors I meet don't read financial reports in detail. Which is fine for the average retail investor. The work can be extensive and exhaustive. Plus if you don't have the right training, professional investors will outwork you. That's why they make the big bucks.

So for years investors have attempted simplify valuation formulas to simpler methods. Most investors are familiar with the popular financial ratios but I'll explain one method I've been working on recently.

Graham's Earnings Yield

The P/E ratio. This is the most popular and simplest way to understand the earnings yield for a company. Initially, Benjamin Graham was best known for buying stocks well below their book value. Screening for net-nets if you will.

He wrote about these methods extensively in the Intelligent Investor and Security Analysis. Both books I recommend reading. Buffett was known to use the same methods when he ran first investment partnership.

In fact, Buffett inversed the market P/E ratio to understand the equity market's earnings yield (i.e. a P/E ratio of 25x would yield 4%). If the fixed income markets returned higher yields (+5%), he would rebalance his portfolio accordingly. I think this methodology is still applicable today. Interest rates were at zero for years, which made equities the best returning investments for everyone. Retail or professional.

Greenblatt's Magic Formula

If you've studied value investing over the past 30 years, you've probably come across Joel Greenblatt. His Magic Formula was popularized in the 90s and early 2000s. When Greenblatt was active in the value investing scene. In many ways, he relaunched the Benjamin Graham investment style.

Joel is a legend. But no formula is ever simple. You still need to do thorough research on the company. So he helped investors learn his methods in a few different ways.

For starters, he back tested the formula with his own hedge fund, Gotham Capital, and outperformed the market for a decade. Investors made $500 million after he was able to deliver 50% annualized returns for years. After closing the fund, he did a few things to give back.

First, he started teaching value investing classes for MBA students at Columbia University. Just like Benjamin Graham. Then he launched the Value Investors Club website in 1999. Which had an excellent screening process to identify high quality investment ideas. It was how Greenblatt found and funded Michael Burry from the Big Short.

Next he published his book and the Magic Formula website. Both have been tremendous tools for investors. If you are early in your investment career, I recommend reading The Little Book That Still Beats the Market.

So what is the Magic Formula? It is a more nuanced screening process of Graham's Earnings Yield. During Graham's and Buffett's era, investors had to manually search through the Moody's Manual for stocks. From A to Z.

But today we can use any screening tool and enter in our investment criteria. In this case, Greenblatt suggests investors look for 30 great companies with a high earnings yield and a high return on capital. Which means you will have a relatively concentrated portfolio that requires constant rebalancing.

The Acquirer's Multiple

However in more recent years, I thought Tobias Carlisle did an excellent job writing about simpler valuation methods in his book, the Acquirer's Multiple.

The method is simple. Identify the one metric that activist hedge funds use to screen for takeover targets. In this case, it is EV/EBITDA. Which is the enterprise value divided by the cash flows. Also now known as the Acquirer's Multiple.

Activist investors include private equity and hedge funds. Both are looking into the detailed financials. Which means they want to understand the interest expense, depreciation and much more.

You see, the problem with the P/E ratio is it simplifies too much. If you are not a professional then you'll hear terms like GAAP vs Non-GAAP standards. These are related to the earnings per share. But the Acquirer's Multiple accounts for more factors like the balance sheet and cash flow statement. I like it and think Tobias has an excellent website to show investors how to use it.

The DuPont Analysis

Now to outperform the market, you need to go beyond the typical value investing screening techniques (which any computer can screen for now). Which is how I stumbled upon the DuPont analysis several years ago.

I remember first learning about this method in business school. It was helpful to understand the main drivers for valuing a company. Which for me are the 1) Net Profit Margins, 2) Asset Turnover and 3) Financial Leverage.

This came back to me after years of being a practitioner. Once you've screened all ~7,000 public companies after +5 years, you have a good idea of what's available on the menu.

So if the playing field get leveled for every investor after five years, your returns will also revert back to the mean. Which in this case is the S&P 500 Index or any broad market fund. So you lose any alpha after a few short years. You become beta.

However, in order to deliver alpha, you need an edge. Which is why the DuPont analysis came to mind. Even in the same industries (i.e pharma, restaurants, etc), the returns on equity profiles are different, even amongst the largest players.

After revisiting this formula, I remembered that Buffett also pivoted his investment strategy to do something similar. He went from buying low P/E ratio stocks to screening for companies delivering a minimum 20% ROE over several years. No wonder he's been compounding 20% annually for decades.

I recommend you add the Return on Equity criteria to your screening process. Set the minimum return profile to 15% for the last five years. Once you're familiar with what a good company looks like, raise your screening standards to 20% like Buffett. Then sit back and enjoy the compounding.

Gain an Edge with Seeking Alpha (sponsor)

Since 2016, I have written for Seeking Alpha. It is one of my favorite investment platforms. They provide the most comprehensive research from thousands of independent experts.

Now investors receive in-depth company analysis, real-time news, and actionable investment ideas. However, investors are still challenged with finding the best ideas. Which is where Alpha Picks comes in.

Every month, Alpha Picks subscribers will receive two data-driven stock picks to hold for the long-term. Seeking Alpha will alert investors when ratings shift to Sell and when new picks are added. These picks cover multiple sectors. Plus you will have access to all Alpha Picks (over 20 stocks) on day 1.

And if you subscribe to Alpha Picks today with my link, you will receive $50 off your first year subscription. Unlock exclusive research & alpha-generating insights. Sign up for Seeking Alpha today.