"Investment students need only two well-taught courses –– How to Value a Business, and How to Think About Market Prices."

– Warren Buffett

To find good companies, you should rigorously evaluate them through an understanding of their business and market. Buffett stresses knowing your “circle of competence”: the area in which you make good decisions. For example, he won’t invest in the technology sector because he doesn’t think he’s able to make good decisions about which companies will exist in 20 years. Your area of expertise might be small and that’s fine: what really matters is that you stick to investment decisions in that area.

"What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know."

– Warren Buffett

How does Warren Buffett value a company?]

Buffett uses a definition of valuation adapted from the American economist John Burr Williams. In Buffett’s words:

"The value of any stock, bond or business today is determined by the cash inflows and outflows — discounted at an appropriate interest rate — that can be expected to occur during the remaining life of the asset."

– Warren Buffett

He looks for companies with great prospects for future earnings – though establishing that isn’t easy.

How does he do it? There are a few factors Buffett uses to judge a company’s future. If the company has performed consistently well with high profit margins and minimal debt then that bodes well. He also looks for companies with defensible competitive advantages – he calls them “moats” – as these keep a company afloat ten, twenty or even fifty years from now (with Buffett’s nigh-on permanent investing horizon, that’s particularly important). The other main thing he looks at is the company’s management – more on that in the next session.

So if he finds a good company, he invests? Not always. Market prices are equally important. Once he calculates a company’s value, he wants to buy shares at a price significantly less than that value. He requires a “margin of safety” gap between the actual value and trading value to justify the risk of owning the company. If the company is trading just 1% below its value, it might not be worth the risk. For Buffett, no deal is better than a bad deal.

Because he’s looking for irrationally low prices, Buffett is a big fan of two traditional terrors: falling prices and high volatility. Falling prices create opportunities for bargain buying. And volatility means prices are flying around so there’s a greater chance the wrong price is attached to the stock. ⚡

"A wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses."

– Warren Buffett