How Does Warren Buffett Choose His Stocks?

Fellow investors have long praised—and envied—Warren Buffett's seemingly uncanny ability to pick stocks. By steadfastly following certain investing principles, he has amassed a net worth estimated at $118 billion. So what exactly does he look for in a stock? Here are some clues.

Warren Buffett's Value Investing Approach

Warren Buffett belongs to the value investing school, popularized by his mentor Benjamin Graham. Value investing focuses on the intrinsic value of a particular stock rather than technical indicators, such as moving averages, volume, or momentum. Determining intrinsic value is an exercise in understanding a company's financials, especially official filings such as earnings and income statements.

In making investments for his holding company, Berkshire Hathaway, Buffett follows a longtime and well-publicized strategy, seeking out the shares of businesses with consistent earning power, a good return on equity (ROE), and capable management—and that are also sensibly priced, if not underpriced).

To help guide him in these decisions, Buffett asks several key questions:

How Has the Company Performed?

Companies that have been providing a reliable return on equity (ROE) for many years are more desirable than those that have had only a short period of solid returns, in Buffett's view. And the greater the number of years of good ROE, the better. In order to gauge historical performance, an investor should review at least five to 10 years of a company's ROE, he maintains.

How Much Debt Does the Company Have?

Having a large ratio of debt to equity should raise a red flag, especially if earnings growth has coincided with adding on more debt, such as through acquisitions.

Instead, Buffett prefers earnings growth to come from shareholders' equity (SE). A company with positive shareholders' equity is generating enough cash flow to cover its liabilities and not relying on debt to keep it growing or afloat.

How Are the Company's Profit Margins?

Buffett looks for companies that have a good profit margin, especially those whose profit margins are growing. As is the case with ROE, he looks at the profit margin over several years to discount short-term trends. For a company to stay on Buffett's radar, its management should be adept at growing profit margins year-over-year, a sign that it is also good at controlling operating costs.

How Unique Are the Company's Products?

Buffett considers companies whose products and services can be easily substituted for riskier than companies with more unique offerings. For example, an oil company whose principal product is crude oil may be vulnerable to competitive forces because clients can buy crude oil from any number of other sources, not to mention alternative types of energy.

However, if the company has unique access to a more desirable grade of oil that many businesses need, that might make it an investment worth looking at. In this case, the company's desirable grade of oil could be a competitive advantage that will help produce profits year after year.

In a similar vein, Buffett has long been a major investor in Coca-Cola. While there are many colas and other soft drinks on the market, there is only one Coke.

Reflecting on that investment in Berkshire Hathaway's 2022 annual report, Buffett wrote, "In August 1994—yes, 1994—Berkshire completed its seven-year purchase of the 400 million shares of Coca-Cola we now own. The total cost was $1.3 billion—then a very meaningful sum at Berkshire. The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie [Charlie Munger, Buffett's longtime business partner] and I were required to do was cash Coke's quarterly dividend checks. We expect that those checks are highly likely to grow."

How Much of a Discount Are Shares Trading At?

This is the crux of value investing: finding companies that have good fundamentals but are trading below where they should be. And the greater the discount, the more room for profitability.

Put another way, the goal for value investors like Buffett is to discover companies that are undervalued compared to their intrinsic value. While there is no exact formula for calculating intrinsic value, investors can look at a variety of factors—such as management strength and future earnings potential—to gauge it.

The Bottom Line

Beyond his value-oriented style, Buffett is also known as a buy-and-hold investor. He is not interested in selling stock in the near term to reap quick profits, but chooses stocks that he believes offer solid prospects for long-term growth. His record as an investor speaks for itself.