Buffett-inspired quality & value

What this checklist is trying to capture

Warren Buffett has never published a stock screen. What he has done, across six decades of Berkshire Hathaway shareholder letters, is describe the kind of business he likes to own: one that earns high returns on the money shareholders leave in it, doesn't need much debt to do so, grows its earnings steadily, has enough pricing power to keep margins wide, and throws off real cash rather than just accounting profit. He has also been consistent that a wonderful business is only a good investment at a sensible price.

This checklist turns those ideas into six tests. The first five are about the quality of the business. The sixth is about price. Most large, popular companies pass several quality tests and fail on price. That's expected: the market usually charges for quality.

The tests, and exactly how we compute them

1. Return on equity above 15% for 10 straight years

Return on equity (ROE) is net income divided by shareholders' equity: how much profit the business earns on the capital its owners have in it. We use average equity (start and end of each fiscal year) so a large buyback or share issue late in the year doesn't distort the figure. To pass, every one of the last ten fiscal years must be above 15%. One bad year fails the test. That is deliberate, because the point is consistency, but it means one-off charges can trip it (US tax reform in 2017 did this to several household names).

Caveat: companies that have bought back a lot of stock can have very small or even negative equity, which pushes ROE up artificially (or makes it meaningless). If equity is negative in any year we mark the test as failed and say why.

2. Debt-to-equity below 0.5

Total debt (commercial paper and other short-term borrowings, the current portion of long-term debt, and long-term debt) divided by shareholders' equity at the latest fiscal year end. Lease liabilities are left out. Below 0.5 means the company has less than 50 cents of borrowing for every dollar of owners' equity.

3. Consistent EPS growth

We look at diluted earnings per share for the last eleven fiscal years, which gives ten year-on-year changes. EPS may fall in at most two of those ten years, and must be higher at the end than at the start. EPS is adjusted for stock splits so that, for example, Apple's 2014 and 2020 splits don't look like collapses in earnings.

4. Gross margin above 40%

Gross profit (revenue minus the direct cost of what was sold) as a share of revenue in the latest fiscal year. A consistently wide gross margin is one of the clearest signs of pricing power: customers pay well above what the product costs to make. Banks, insurers and some utilities don't report a gross profit line, so this test shows as "n/a" for them.

5. Positive free cash flow for five years

Free cash flow is cash from operations minus capital expenditure (purchases of property, plant and equipment). It must be positive in each of the last five fiscal years. This catches businesses whose reported profits never turn into cash.

6. Price at or below owner-earnings value

In his 1986 letter Buffett described "owner earnings": roughly, net income plus depreciation and amortisation, minus the capital spending needed to keep the business competitive. We can't see how much capex is maintenance versus growth, so we subtract all of it, which is conservative. We then value that stream as a flat perpetuity at a 10% required return (equivalent to paying ten times owner earnings) and compare it with the company's current market value. To pass, market value must be no more than that estimate.

This is a deliberately simple, no-growth yardstick. A fast-growing company is worth more than ten times today's owner earnings, so failing this test isn't a claim that the stock is overpriced. It shows how much future growth the current price is already counting on.

Limitations

• Buffett's judgement about management, competitive moats and the durability of a business can't be reduced to numbers. This checklist only covers the parts that can.
• All figures come from what companies tag in their SEC filings. Unusual reporting can produce odd results; when a needed figure is missing the test shows "n/a" instead of guessing.
• We use reported figures without adjusting for one-off items. A large one-time gain (such as a spin-off) or charge (such as the 2017 US tax reform) shows up in that year's EPS and ROE, and can make the 10-year tests pass or fail on a single unusual year.
• Thresholds are round numbers chosen to match the spirit of Buffett's writing, not quotes from it.

See how we score for data sources and update timing.