Warren Buffett’s investment philosophy has created extraordinary wealth over six decades, transforming Berkshire Hathaway from a struggling textile company into one of the world’s most valuable corporations. His approach isn’t based on complex algorithms or market timing, but rather on fundamental principles that any investor can understand and apply.
These five essential formulas form the backbone of Buffett’s investment strategy, offering a roadmap for building long-term wealth through intelligent stock selection. He also used these principles to acquire whole businesses for Berkshire Hathaway and grow it into one of the biggest companies in the world.
1. The Value Investing Formula: Buy Below Intrinsic Value
At the heart of Buffett’s strategy lies the concept of intrinsic value, which represents what a company is truly worth based on its ability to generate cash over its lifetime. This calculation extends far beyond simply examining current earnings or book value. Instead, it involves projecting the value of future cash flows the business will produce and discounting them back to present value.
Buffett learned this approach from his mentor Benjamin Graham, but he refined it by focusing more heavily on the quality and predictability of those future cash flows. When evaluating a company, he estimates all the cash it can generate from now until judgment day, then determines what that stream of money is worth today. This requires analyzing the company’s competitive position, management quality, and industry dynamics to project sustainable earnings power.
The key to this formula is the margin of safety. Buffett typically seeks to purchase stocks trading at least 25% to 50% below his calculated intrinsic value. His mentor, Graham, focused on book value and current earnings as a measure of inherent value, while Buffett learned to focus on future growth potential, thanks to Charlie Munger.
This cushion protects against errors in judgment and unforeseen business challenges. If he determines a company is worth $100 per share based on discounted future cash flows, he might wait until it trades at $50 to $75 before buying. This patience has been crucial to his success, as it dramatically reduces the risk of permanent capital loss while increasing the odds for future potential returns.
2. The Debt-to-Equity Formula
Buffett’s approach to leverage is refreshingly straightforward: he calculates the debt-to-equity ratio by dividing total liabilities by shareholders’ equity, and he strongly prefers companies with ratios below 0.5. This conservative stance on debt stems from his belief that great businesses shouldn’t need to borrow heavily to grow.
Companies with low debt have multiple advantages that appeal to Buffett. They can weather economic storms without facing bankruptcy risk, they have the flexibility to pursue opportunities during downturns when competitors are struggling, and they generate returns through operational excellence rather than financial engineering. High debt levels, conversely, can exacerbate problems during tough times and compel companies to make short-term decisions that compromise long-term value.
Buffett particularly admires businesses that generate so much cash internally that they can fund all their growth initiatives without external financing. These companies exemplify the kind of economic strength that fosters compound wealth creation over the course of decades. When a business can consistently grow using only its retained earnings, it demonstrates that management is creating real value rather than simply expanding through acquisitions or leveraging debt.
3. The Return on Equity (ROE) Formula
Return on equity serves as Buffett’s primary scorecard for management effectiveness. Calculated as net income divided by shareholder equity, ROE reveals how efficiently a company transforms investor capital into profits. Buffett seeks companies that consistently generate ROE above 15% without using excessive leverage to boost their numbers.
What makes ROE so valuable to Buffett is its ability to reveal sustainable competitive advantages. A company that consistently maintains a high ROE year after year likely possesses some exceptional qualities that keep competitors at bay. This might be a powerful brand, unique technology, or cost advantages that others can’t replicate. These businesses naturally compound wealth because they can reinvest their earnings at high rates of return.
Consistency matters more than occasional spectacular performance. Buffett prefers companies that deliver steady 20% ROE over many years rather than those that alternate between 40% returns and losses. This reliability indicates a durable business model that can compound wealth through various economic cycles. It also suggests honest, capable management that can maintain operational excellence over time.
4. The Owner Earnings Formula
While most investors focus on reported earnings per share, Buffett calculates what he calls “owner earnings” to understand the true cash-generating power of a business. This formula begins with net income, adds back depreciation and amortization (non-cash expenses), and then subtracts capital expenditures. Additional working capital is required to maintain the company’s competitive position and unit volume.
This calculation reveals how much cash genuinely flows to owners after the business funds all necessary investments. Many companies report impressive earnings but require constant reinvestment to maintain their market position, leaving shareholders with little actual cash to benefit from. Buffett avoids these capital-intensive businesses in favor of those generating substantial free cash flow.
The beauty of focusing on owner earnings is that it cuts through accounting complexity to reveal economic reality. A software company might report lower earnings due to high amortization charges but generate a tremendous cash flow that requires minimal reinvestment. Conversely, a manufacturing company might report steady profits while consuming all its cash in equipment upgrades. Owner earnings expose these crucial differences that traditional metrics might obscure.
5. The Economic Moat Formula
Buffett’s concept of economic moats represents perhaps his most important contribution to investment thinking. He seeks businesses with sustainable competitive advantages that protect their profits from erosion by competitors. These moats take various forms, each creating barriers that prevent rivals from stealing market share or forcing price reductions.
Strong brands create moats by commanding customer loyalty and premium pricing. Network effects build moats when products become more valuable as user bases grow. High switching costs lock in customers who would face significant expenses or inconvenience if they were to change providers. Cost advantages from scale, unique assets, or superior processes create moats by enabling companies to underprice competitors while maintaining healthy margins.
The width and durability of these moats determine how long a company can maintain above-average returns on capital. Buffett evaluates moats by asking whether a competitor with unlimited resources could successfully challenge the incumbent’s position.
If the answer is no, the company likely possesses the kind of sustainable advantage that creates long-term value. This framework explains why he has held positions in companies like Coca-Cola and American Express for decades, confident that their moats will protect returns far into the future.
Conclusion
Warren Buffett’s five formulas work together as an integrated system for identifying exceptional investments. By combining intrinsic value calculations with careful attention to debt levels, return on equity, owner earnings, and competitive moats, investors can identify businesses capable of compounding wealth over decades.
These principles have proven their worth across different market conditions and economic cycles, demonstrating that successful investing depends not on predicting short-term market movements but on understanding business fundamentals and having the patience to let the power of compounding work its magic.
While applying these formulas requires discipline and emotional fortitude, they offer any investor a time-tested path to building lasting wealth through the stock market.