Book summary "Warren Buffett and the Interpretation of Financial Statements"
Warren realized that if a company’s competitive advantage could be maintained for a long period of time—if it was “durable”—then the underlying value of the business would continue to increase year after year.
Warren likes to think of these companies as owning a piece of the consumer’s mind, and when a company owns a piece of the consumer’s mind, it never has to change its products, which, as you will find out, is a good thing.
In people-specific firms workers can demand and get a large part of the firm’s profits, which leaves a much smaller pot for the firm’s owners/shareholders.
So when Warren is looking at a company’s financial statement, he is looking for consistency.
- Does it consistently have high gross margins?
- Does it consistently carry little or no debt?
- Does it consistently not have to spend large sums on research and development?
- Does it show consistent earnings?
- Does it show a consistent growth in earnings?
We need to look for consistent pattern in every calculated ratios.
Analyze earnings
- We have to understand the source of earnings: business operations, selling assets, investment activities, etc.
- Expenses:
- avoid companies with high research costs, high selling and administrative costs, and high interest costs on debt.
- if we see a company that is repetitively showing SGA expenses close to, or in excess of, 100%, we are probably dealing with a company in a highly competitive industry where no one entity has a sustainable competitive advantage
- companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long-term economics at risk, which means they are not a sure thing
- depreciation is a very real expense and should always be included in any calculation of earnings
- High gross profit margin (gross profit / total revenues)
- ≤ 20% means fierce competition
- ≥ 40% means good
- Low depreciation / gross profit
- Low interest payments / operating income
- ≤ 15% for consumer products industry
- Removing nonrecurring events from net earnings
- Upward historical net earnings / total revenues trend
- ≥ 20%
- Per-share earnings: upward trend during a long period (e.g., 10 years)
Analyze the balance sheet
- High number of cash and cash equivalents means:
- competitive advantage
- or the company just sells a business or bonds, which is a bad thing
- Surplus of cash should come from the ongoing business. Cash is king in troubled times.
- Manufacturing companies: upward trend of net earnings and inventory
- Net receivables = Receivables - Bad debts. Low net receivables / gross sales is good signal
- Company with a durable competitive advantage will be able to finance any new plants and equipment internally. But a company that doesn’t have a competitive advantage will be forced to turn to debt to finance its constant need to retool its plants to keep up with the competition.
- Whenever we see an increase in goodwill of a company over a number of years, we can assume that it is because the company is out buying other businesses
- Huge assets could be an competitive advantage. E.g., raising $43 billion to take on Coca-Cola is an impossible task—it’s not going to happen but raising $1.7 billion to take on Moody’s is within the realm of possibility.
- Short-term debts / long-term debts should be low
- Little or no long-term debts to finance company’s operations is preferred
- 3-4 year of net earnings should be able to pay off all the long-term debts
- Debt to Shareholders’ Equity Ratio = Total Liabilities ÷ Shareholders’ Equity should be low because good companies should finance their operations with their own earnings
- Good companies don’t like to have any preferred stock
- Retained earnings (net earnings - dividends - stock buy-back)
- upward trend
- negative retain earnings could also be a good thing
- Presence of treasury stock is a good signal
- Shareholders’ equity has three sources. One is the capital that was originally raised selling preferred and common stock to the public. The second is any later sales of preferred and common stock to the public after the company is up and running. The third, and most important to us, is the accumulation of retained earnings.
- Net Earnings divided by Shareholders’ Equity equals Return on Shareholders’ Equity. We expect a higher-than-average return on shareholders’ equity.
Analyze the cash flow
- Capital expenditures / Net earnings: lower is better
- Issuance (Retirement) of Stock, Net: to see if the company is buy back its shares