Financial Tenets

• Focus on return on equity, not earnings per share.
• Calculate "owner earnings" to get a true reflection of value.
• Look for companies with high profit margins.
• For every dollar retained, has the company created at least a dollar of market value?

The test of economic performance, Buffett believes, is whether a company achieves a high earnings rate on equity capital (without undue leverage, accounting gimmickry, etc.), not whether it has consistent gains in earnings per share.
To measure a company's annual performance, Buffett prefers return on equity - the ratio of operating earnings to shareholders' equity.
To use this ratio, we need to make several adjustments.
First, all marketable securities should be valued at cost & not at market value, because values in the stock market as a whole can greatly influence the returns on shareholders' equity in a particular company. For example, if the stock market rose dramatically in one year, thereby increasing the net worth of a company, a truly outstanding performance would be diminished when compared with a larger denomination. Conversely, falling prices reduce shareholders' equity, which means that mediocre operating results appear much better than they really are.

Second, we must also control the effects that unusual items may have on the numerator of this ratio. Buffett excludes all capital gains & losses as well as extraordinary items that may increase or decrease operating earnings. He is seeking to isolate the specific annual performance of a business. He wants to know how well management accomplishes its task of generating a return on operations of the business given the capital it employs. That, he says, is the single best measure of management's economic performance.

Furthermore, Buffett believes that a business should achieve good returns on equity while employing little or no debt.Companies can increase their return on equity by increasing their debt-to-equity ratio. But Buffett believes good business or investment decisions will produce quite satisfactory economic results with no aid from leverage. Furthermore, highly leveraged companies are vulnerable during economic slowdowns.

Instead of focusing on cash flow, Buffett prefers to use what he calls "owner earnings" a company's net income plus depreciation, depletion, amortization, less the amount of capital expenditures & any additional working capital that might be needed.

Buffett's goal is to select companies in which each dollar of retained earnings is translated into atleast one dollar of market value.
Buffett believes that if he has selected a company with favorable long-term economic prospects run by able & shareholder-oriented managers, the proof will be reflected in the increased market value of the company. He uses a quick test: The increased market value should at the very least match the amount of retained earnings, dollar for dollar. If the value goes higher than the retained earnings so much the better.

(Source: The Warren Buffett Way by Robert G. Hagstrom)