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What makes a great investment?

Young female business analyst looking at a graph chart while working from home
Young female business analyst looking at a graph chart while working from home

Investing in the stock market can be a great way to build wealth over time. But it’s also risky. With that in mind, how do I find great investment opportunities?

According to Warren Buffett, the best investments have two main characteristics. First, they are in quality businesses. Second, they involve buying shares at decent prices.

Great businesses

According to Buffett, it’s better to buy a great business at a fair price than to buy a fair business at a great price. That means that the most important thing is finding a quality company to invest in.

What are the characteristics of a quality business? The Oracle of Omaha suggests that there are three main features.

The first is efficiency. The best businesses are ones that can generate significant amounts of cash without requiring much reinvestment.

Rightmove is a great example of this type of business. The company generates £193m in cash from its operations and uses just under 1% of this in maintaining its assets.

The second is growth. Buffett says that what makes an investment increase in value isn’t the cash it distributes, but the cash it retains and uses to increase its future income.

A good example of a company that does this well is Halma. While the company does pay a dividend, it uses the majority of its cash to acquire other businesses, causing its future income to grow.

Third is an advantage over the competition. In some ways, this is the most important feature – having a business that generates a lot of cash isn’t much good if nothing stops other companies from competing.

I think that Experian is an example of a company with a strong competitive position. The company’s products are built on a database that is extremely difficult for a competitor to replicate.

Fair price

Finding a quality business is important, but it’s important to avoid overpaying for shares. According to Buffett, any investment can be a bad investment at the wrong price.

What is a fair price for a stock? Buffett says that the answer comes down to how much cash the business is going to generate in the future and what interest rates are.

Apple, for example, currently generates $6.11 in earnings per share. Exactly how much I should pay for a share of Apple depends on how much the company’s earnings are going to increase in future.

If Apple increases its earnings at 10% per year for the next 10 years, then the company will generate around $11 on average each year over the next decade.

That means that if I want to average an 8% return on my investment per year, I’m going to buy Apple shares at or below a price of $137. For a 5% return, I’d be looking for a share price below $220.

A great investment is one where the current share price is low based on reasonable expectations of the company’s future earnings. This allows for a good investment return.

Great investments

Warren Buffett makes finding a great investment look easy. It’s about identifying a quality business at a reasonable price.

For investors like me, it isn’t always so straightforward. But if I can follow Buffett’s approach, then investing in the stock market could really boost my net worth.

The post What makes a great investment? appeared first on The Motley Fool UK.

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Stephen Wright has positions in Apple, Experian, Halma, and Rightmove. The Motley Fool UK has recommended Apple, Experian, Halma, and Rightmove. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Motley Fool UK 2022