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Stepan Lavrouk
Stepan Lavrouk
Articles (583) 

Buffett, Munger Explain the Most Important Metric to Look for When Investing

You can understand a business by looking at this one part of its financial statements

July 09, 2020 | About:

At the 2008 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) annual investor conference, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) were asked whether they would invest in a business without being able to talk to its management team or reading its annual reports, and only having access to its financial statements. They were also asked what the single most important metric in investing is to them. Here’s what the duo had to say on the matter.

The essence of investing

All real investing is just laying out money today in order to get more money in the future. It doesn’t really matter what you are investing in: the stock of a technology company, government bonds, commercial real estate, farmland - all that really matters is the future cash flows of the assets that you are purchasing. To the long-term investor, it doesn’t really matter what the market for that asset will be in the near future. You are buying for the income the asset produces, not for the right to sell it to the next bidder.

Buffett and Munger believe it is possible to appraise a business solely based on its financial statements - provided that you understand the industry that it operates in. For instance, you may be thinking of investing in a consumer retailer. If you have a good feel for what the average profit margins are in this sector, how much debt similar businesses take on and how a retailer should be utilizing its free cash flow, then you probably don’t need to talk to the CEO. In fact, Buffett went on to say that Berkshire has frequently invested just based on financial statements

With all that being said, it is perhaps unsurprising that Munger believes that the most important metric to look at when valuing a business is its cash flow, a point which he illustrated with an anecdote:

“We tend to prefer the business which drowns in cash - it just makes so much money that one of the main characteristics of it is the amount of cash coming in. There are other businesses, like the construction equipment business that my old friend John Anderson ran. He used to say: 'you work hard all year, and at the end of the year there’s your profit - sitting in the yard.' There was never any cash, just more used construction equipment. We tend to hate businesses like that.”

It’s difficult to evaluate businesses which are constantly cash-strapped, no matter how valuable management considers its inventory to be. It really is much easier to just follow the cold hard cash.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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