Factors to identify the Indian companies that are worth investing in.
STABILITY OF EARNINGS:
This can be checked by considering the earnings per share (EPS) for the past 10 years. EPS is derivedfrom the residual profit left after payment of all expenses, taxes, depreciation, interest, preferencedividends and belongs entirely to equity shareholders. A company should not have a negative EPS in thepast 10 years. If the EPS is lower than that in the previous year, the dip should not be more than 45%.
DEBT TO EARNINGS RATIO:
The second variable is the level of long-term debt to earnings ratio. Buffett likes conservatively financedcompanies. He prefers the long-term debt of a company to have been paid off from its net earnings inless than five years. This implies that the long-term debt to earnings ratio should be less than or equal tofive.
RETURN ON EQUITY (ROE):
The third variable measures how much money a company earns on its equity. The ratio is generallyexpressed as a percentage. For a company to figure on Buffett's radar, its 10-year average ROE shouldbe greater than or equal to 15%.
RETURN ON TOTAL CAPITAL (ROTC):
This variable can sometimes give an incorrect picture. It's because some companies have a high debtcontent in their capital structure in relation to their equity. Still, they will show a high ROE because of the low equity base. However, a high debt content makes the company risky as the debt needs to beserviced, irrespective of the company being profitable or not. ROTC overcomes the limitation of ROE.Buffett prefers the companies whose 10-year average ROTC is greater than or equal to 12%.
FREE CASH FLOW:
Buffett does not pick stocks of companies that indulge in major capital expenditure. Free cash flow isthe difference between operating cash and capital expenditure. Therefore, free cash flow should be apositive. A company with a positive free cash flow is generating more cash than it is consuming and thisis a good sign.
RETURN ON RETAINED EARNINGS:
The next variable is the return on retained earnings. Buffett uses this to assess the management'sperformance. The variable gives an indication of the ability of the management to use retained earningsfor shareholders' wealth creation. To be eligible for investment by Buffett, a company's 10-year return on