The extraordinary thing about the Warren Buffett method is that it is actually quite simple and relies on only two numbers that are used in conjunction with a couple of figures from the accounting statements.

One of the numbers is the price/earnings ratio which is the multiple of annual profits an investor is prepared to pay for buying the share of a company. The other number is the return on equity which is the profit in percentage that investors get in return for the capital invested in the company (this capital is called Shareholders’ Equity).

It is best to use the historical average of the price/earnings ratio and the time-weighted (or historical average) return on equity figure as this approach gives a more conservative valuation than relying on the latest price/earnings ratio and return on equity figures which can be more volatile than the average or time-weighted figures (in this case, time-weighting of the return on equity means using a return on equity that is half of the historical average and half of the latest quarterly figure).

The computation of the Warren Buffett valuation is done the following way (sources for the method can be found by searching the web for keywords such as “Warren Buffett Valuing Stocks”):

1/ Shareholders’ equity is divided by the number of shares issued by the company in order to get the shareholders’ equity per share.

2/ The time-weighted return on equity is then raised to the power of the length of time required in the investor’s horizon. As ThinkLikeWarrenBuffett.com takes the view that individual investors tend to have a 9-month horizon, the return on equity is raised to the power of the number 0.75 which represents 9 months as it is three quarters of 1 (1 represents one year).

3/ The result of the previous calculation (in step 2) is then multiplied by the shareholders’ equity per share (from step 1) in order to obtain the Earnings per Share at the end of the desired horizon, in our case nine months.

4/ Finally, the Earnings per Share in nine months (from step 3) is multiplied by the historical average of the price/earnings ratio in order to obtain the “Warren Buffett Valuation”.

ThinkLikeWarrenBuffett.com users have access to easy-to-understand valuation graphs that show the “Warren Buffett Valuation” for each stock as well as the actual share price, therefore understanding at a glance whether the stock has potential according to the Warren Buffett method.

Warren Buffett is known to quote the Margin of Safety ratio of 25% which means that he prefers to invest in a stock only if the share trades at 75% or less than his valuation for that stock. Therefore, ThinkLikeWarrenBuffett.com graphs also include the Margin of Safety line.