The world’s most admired investor is sitting on a record amount of cash while stock markets continue to reach new highs. How does he decide whether the market has become too expensive? The answer lies in a formula so simple that anyone can understand it.

Imagine having more than 300 billion dollars available to invest and, despite that, deciding to wait. That is exactly what Warren Buffett has done in recent years while stock markets have continued to reach record highs.

While almost everyone else is rushing to buy, he prefers to stay on the sidelines. Not because he has lost confidence in businesses or because he believes a major crisis is just around the corner, but because he believes that, more often than not, the best investment is patience.

It is this way of thinking that has turned Buffett into a true legend of finance.

The oracle of Omaha

At 94 years old, Warren Buffett remains one of the most influential figures in the world of investing. As the head of Berkshire Hathaway, he has built a fortune that consistently places him among the wealthiest people on the planet. Yet his reputation is not based solely on his wealth.

Buffett is admired because he has achieved something extraordinarily difficult: delivering outstanding returns for more than six decades without being carried away by market fashions or periods of euphoria.

Perhaps that is why he is known around the world as the Oracle of Omaha, the American city where he still lives in the same house he bought more than sixty years ago. His philosophy is as simple as it is demanding: invest only when the price makes sense.

In fact, one of his best-known quotes perfectly sums up his approach to investing: “Price is what you pay. Value is what you get”.

A formula anyone can understand

To determine whether the market has become too expensive or still offers attractive opportunities, Buffett often looks at a remarkably simple indicator.

It compares the total value of all publicly traded companies with the country’s gross domestic product (GDP). In other words, it measures what investors are willing to pay for businesses against the wealth generated by the real economy.

The idea is almost common sense. If the value of all listed companies grows much faster than the economy that supports them, it is reasonable to ask whether prices may have risen too far.

The bakery example

Imagine a bakery that generates half a million euros in annual revenue. It has loyal customers, a stable business and still has room to grow. But if someone asked us to pay five million euros to buy it, we would probably pause for a moment before saying yes.

Not because the bakery is a bad business.But because we would want to know whether that price is justified. The Buffett Indicator asks exactly the same question, but applies it to the stock market as a whole.

So, what does it tell us today?

Today, the Buffett Indicator in the United States remains well above its historical average. That does not mean a market correction is imminent, nor does it mean that stock prices will collapse tomorrow. Markets can remain highly valued for long periods of time.

What it does suggest is that investors are paying a very demanding price for companies’ future earnings and that, when this happens, the margin for error tends to become much smaller.

Like any indicator, it is not infallible. Large American multinational companies generate a significant share of their revenues around the world, which means that comparing them solely with the U.S. GDP has its limitations. That is why economists see it as a compass rather than a crystal ball.

A lesson that goes beyond the stock market

Perhaps Warren Buffett’s greatest contribution is not this indicator, but the way he thinks about investing. While many people try to predict what the stock market will do next week, he continues to ask himself a much simpler question: does the price I’m paying really make sense?

It is a way of thinking that applies just as much to buying shares as it does to purchasing a home, investing in a business or making any important financial decision.

Because, in the end, markets can change their mood from one day to the next. But common sense remains one of the most profitable investments anyone can make.

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