Definitions:
10Qs: Quarterly financial statements.
10K: Annual report.
Short vs. long term liabilities: 1 year is the cutoff.
Current assets: cash or can be converted to cash in less than a year.
This summary only includes the parts of the book about interpretation of financial statements. The last part of the book about Warren’s Buffett’s method of valuing companies is in itself a huge topic, which I’ll summarize later.
When Warren Buffett selects a company, one of the most important factors he studies is having a durable competitive advantage. To assess competitive advantage, he studies financial statements. A company should have one of the following to have durable competitive advantage:
- Unique product.
- Unique service.
- A product/service that’s consistently needed.
- A product that it buys and sells at low prices.
The income statement:
Revenue is the money that comes in.
Gross profit = revenue — costs of good sold
Gross profit margin (%) = gross profit / revenue * 100
Operating profit = gross profit — operating expenses
Gain (loss) on sales of assets = the asset’s sales price — the asset’s value on the books
Income before tax = operating profit — (interest expenses + sale assets + others)
Net earnings = income before tax — income tax
Per-share earnings = net earnings / number of shares
Gross profit margin:
- Higher gross profit margin is consistently associated with excellent long-term outcomes.
- A high gross profit margin is created by the company’s durable competitive advantage.
- Examples of good gross profit margin: Coca-Cola (60%), Moody’s (73%), Wrigley (51%).
- Examples of bad gross profit margins: United Airlines (14%), General Motors (21%), Goodyear Tire (20%).
- Companies with high operating expenses can lead to bad future despite good gross profit margin.
Operating expenses:
Operating expenses include research and development, selling and administrative costs, depreciation…etc.
- Selling, general and adminstrative expenses (SGA):
‘SGA/gross profit’ ratio can vary between companies (25% for Moody’s and 59% for Coca-cola).
Consistency is key.
Changes in this ratio are a bad sign (Ford from 89% to 780% or GM from 23% to 83%). Changes in the ratio can be caused by decreased sales, leading to decreased revenue with the same SGA.
- Research and development (R&D):
The continuous need for high costs of R&D is an indicator of potential loss of competitive advantage.
Examples include Intel that spends 30% of its gross profit on R&D.
Another examples is Coca-Cola that does not have any significant R&D costs, despite very high SGA costs due to advertising.
- Depreciation:
Depreciation is a REAL expense and MUST be included.
Be wary of companies hide depreciation to artificially increase earnings.
Lower depreciation rates is associated with better competitive advantage.
Examples of low depreciation costs to gross profit include Coca-Cola (6%), Wrigley’s (7%).
Examples of high depreciation costs to gross profit include GM (22–57%).
Financial costs (interest):
- It’s isolated on its own because it’s not associated with any production or sales activities.
- Little or no interest expenses are a good indicator of companies with competitive advantage.
- Examples of good interest to operating income ratio include Proctor and Gamble (8%), Wrigley (7%), Southwest airlines (9%).
- High interest payments relative to operating income is often associated with one of the following:
1) Low competitive advantage of the company.
2) The company was bought in a leveraged buyout.
- Examples of high interest to operating income ratio include Goodyear (49%), United airlines (61%) American airlines (92%).
Net earnings:
- Net earning for a single year is useless.
- Long-term upward trend of net earnings is an indicator of the durability of the competitive advantage.
- Distinguish between historical net earnings and historical per-share earnings. Share repurchases programs can affect per-share earnings.
- A company with competitive advantage will have a higher net earnings to total revenue ratio than other competitors. This ratio is more important than absolute net earnings.
- Examples of high ratio include Coca-Cola (21%), Moody’s (31%).
- Examples of low ratio include Southwest airlines (7%), GM (3%). Note than both suffer from lousy economics because of the super competition in these fields.
Per-share earnings:
- Similar to net earnings, a single per-share earning is useless. Look at 10 years.
- A 10-year upward trend of per-share earnings is an indicator of the durability of the competitive advantage.
- Stock buybacks leads to increased per-share earnings.
- Fluctuating demand and high competition lead to fluctuating and unstable earnings.
The balance sheet:
Assets - liabilities = net worth (or shareholders’ equity)
Current asset cycle: Cash ⇒ inventory ⇒ accounts receivable ⇒ cash
Net receivable = Total receivables - an estimation of bad debts
Total current assets = cash and cash equivalent + inventory + net receivables + prepaid expenses + other current assets
The current ratio = current assets / current liabilities
Total assets = Total current assets + total long-term assets
Return on assets = Net earnings / total assets
Total current liabilities = accounts payable + accrued expenses + short-term debt + long-term debt due + other current liabilities
Total liabilities = total current liabilities + total long-term liabilities
Shareholders’ equity = total assets- total liabilities
Shareholders’ equity = preferred and common stocks + pain in capital + retained earnings - treasury stocks
Debt to shareholders’ equity ratio = total liabilities / shareholders’ equity
Retained earnings = After-tax net earnings — (costs of dividends + costs of buying back stocks)
Return on shareholders’ equity = net earnings / shareholders’ equity
Current assets:
Cash and cash equivalents:
- A company with a lot of cash isn’t necessarily doing well. The cash may be from selling assets or bonds.
- During a short-term business problem (causing the stock to go down), a company with a lot of cash and marketable securities and little or no debt is likely to survive the hard times.
- a company with a lot of debt and low cash is a sinking ship.
- As always, one year is useless. Study 7 years.
Inventory:
- Companies with inventory that is unlikely to go obsolete are preferred.
- A good indicator of companies with durable competitive advantage is a parallel rise in both inventory and net earnings. This means that the company is finding more ways to increase sales, and is able to increase inventory to fulfil the demand.
- Companies with no competitive advantage will show years of rapid increasing inventory followed by rapid decreases.
Net receivables:
- Receivables is cash that will come to the company in the near future.
- Since some debts will never be paid, net receivables are receivables after deducting an estimation of bad debts .
- On its own, net receivables amount may not tell a lot. However, comparing it with competing businesses in the same field is helpful.
- Companies with relatively lower net receivables to gross sales than competitors are usually the ones with high competitive advantage, eliminating their need to market their products by offering financing.
Total current assets:
- This number is key to determining the ability of the company to meet its short-term obligations.
- Traditionally, analysts have argue that good companies must always have a current ratio (current assets/current liabilities) that is higher than 1.
- Counterintuitively, many companies with durable competitive advantage have a current ratio that’s lower than 1.
- Examples of this includes Moody’s (0.64), Coca-cola (0.95), Proctor & Gamble (0.82).
- This is explained as these companies have strong earning power making it easy to cover current liabilities. In such cases, the current ratio is useless.
Long-term assets:
Property, plant, and equipment:
- Carried on book as original costs less accumulated depreciation.
- These become ongoing expenses in companies with no competitive advantage due to the continuous need of upgrades before wear-out.
- Companies with durable competitive advantage do not need constant upgrades.
- Look at how this is financed! Companies with durable competitive advantage can finance this internally without the need for debt.
Goodwill:
- When company A buys company B for higher than the book value of B, goodwill is the difference between the real and paid values of B.
- Increasing goodwill indicates the continuous acquisition of other businesses.
- Companies with durable competitive advantage almost always sell with a value higher than books.
Intangible assets:
- These include patents, copyrights, trademarks, franchises, brand names…etc.
- Internally developed intangible assets CANNOT be carried on the balance sheet. Only intangible assets acquired from a third-party are carried.
- The names of many companies with durable competitive advantages like Coca-cola, Walmart, Pepsi…etc. thus cannot be carried on balance sheets despite being worth billions.
- The internally developed brand name (like Coca-Cola), can thus be considered a hidden value carrier that many investors don’t see early.
Long-term investments:
- Can be internal or external investments.
- It MUST be carried on the balance sheet as whichever is lower: books cost or market price. It cannot be marked higher even if it appreciates. This can be a hidden value.
- External long-term investments tell us about the company’s mindset.
Total assets:
- The return on total assets is an important measure of the efficiency of the company.
- On the other hand, high costs can be an entry barrier for new competitors. Such companies can maintain competitive advantage (difficult for competitors to enter) while also having relatively lower return on assets (because of high value of assets).
- Examples include Coca-cola ($43 billion assets and 12% return) and Proctor & Gamble ($143 billion assets and 7% return).
- This means that very high returns on total assets can sometimes indicate vulnerability in the competitive advantage, because of the easiness of competitors to enter.
- Examples include Moody’s ($1.7 billion in assets and 43% return).
Current liabilities:
Accounts payable, accrued expenses, and other current liabilities:
- Accounts payable is money owed to suppliers for which the company got the invoice but hasn’t paid yet.
- Accrued expenses is money that has yet to be invoiced for. It includes sales tax payable, wages payable, and accrued rent payable.
Short-term debts:
- Short-term money historically has been cheaper than long-term money.
- An investing strategy is to borrow short-term money and lend it at a higher interest. Then keep rolling over the debt with short-term debts. Risks associated with this strategy include the increase in short-term interest rates, and the inability to get more short-term debts. Think Bear Stearns (and many other banks) in the great recession.
- Examples include Bank of America which has $2.09 of short-term debt for every dollar of long-term debt.
- A safer, but harder, strategy is to borrow long-term and lend long-term.
- Examples include Wells Fargo which has 57 cents of short-term debt for every dollar of long-term debt.
- These institutions are more durable and less vulnerable to sudden shifts.
Long-term debt coming due:
- It’s the portion of the long-term debt that needs to be paid in the current year.
- Adding this to short-term debts creates the illusion of higher short-term debt.
- A company that always has a lot of long-term debt coming due, probably lacks competitive advantage, and is at risk of bankruptcy.
- A company with a single bad event leading to too much long-term debt in the years ahead, may be bought at a discount.
Long-term liabilities:
Long-term debt:
- Companies that have a durable competitive advantage have little or no long-term debt.
- Look at the long-term debt load that the company has been carrying for the last 10 years.
- A good company generally has enough yearly net earnings to pay off all of its long-term debts within 3–4 years.
- Moody’s and Coca-cola can pay all their long-term debts in a single year using net earnings.
- Net earnings of GM and Ford for 10 years are not enough to pay their long-term debts.
Deferred income tax, minority interest, and other liabilities:
- Deferred income tax is tax that’s due but not paid yet.
- When company A acquires 80% or more of company B, company A has the right to add 100% of company B’s income and assets to its books. Minority interest is the value of the remaining of company B that company A does not own.
Total liabilities:
- Theoretically, well-performing companies should have a lower debt to shareholders’ equity ratio (meaning less debt).
- On the other hand, many great companies with curable competitive advantage do not need large equity and retained earnings, leading also to having a relatively high debt to shareholders’ equity.
- Another important factor is the buyback of stocks which can lead to higher ratio because of lower shareholders’ equity.
- Examples of this include Moody’s. Before adjusting for stocks buybacks, Moody’s has a relatively high debt to shareholders’ equity ratio. However, after adjustment, the ratio goes down to 0.63.
- Examples of companies performing bad include Goodyear tire (adjusted ratio 4.35) and Ford (adjusted ratio 38).
- These rules do not apply to financial institutions (banks).
Shareholder’s equity/book value:
Stocks par value: the value of the stocks in the company’s charter.
Preferred and common stocks:
- Common stock owners have the right to elect a board of directors. They may receive dividends.
- Preferred stocks receive dividends and have the priority to get paid if the company goes bankrupt.
- The term ‘paid in capital’ refers to the excess money paid above the par value when the stock was sold.
- Many companies with durable competitive advantage issue few or no preferred stocks. The reason is that these stocks require expensive dividend payment that cannot be deducted from taxes (in contrast to taking a debt with a deductible interest).
Retained earnings:
- This is one of the most important indicators of durable competitive advantage.
- It’s the earnings that are kept in the company to improve it, and not paid as dividends or stocks buyback.
- It’s an accumulative number; new retained earnings are added to previous total.
- Examples of companies with good rate of growth of retained earnings over 5 years include Coca-cola (7.9% annually), Wrigley (10.9% annually), Berkshire Hathaway (23% annually).
- Some times an increase in retained net earnings can be due to an acquisition.
- GM has negative retained earnings because of poor economics,
- Microsoft has negative retained earnings because of dividend payments and stocks buyback.
Treasury stocks:
- When a company buys back stocks, they are either cancelled, or kept as treasury stocks (until being re-issued again).
- Treasury stocks do not have voting rights and do not receive dividends.
- Despite being an asset, they lower the shareholders’ equity and are carried as a negative on the balance sheet.
- More treasury stocks ⇒ less company’s equity ⇒ higher return on equity (financial engineering)
- Companies with durable competitive advantage have treasury stocks.
- Due the possibility of financial engineering mentioned above, it’s important to determine the cause of increases in return on equity and adjust for financial engineering effects to determine the increase in return on equity resulting from good economics. To do this:
- Add the value of treasury stocks (as a positive number) to the shareholders’ equity to get total shareholders’ equity.
- Divide the company’s net earnings by the new (positive) total shareholder’s equity.
- The resulting number will be the return of equity not resulting from financial engineering.
Return on shareholders’ equity:
- Intuitively, companies with durable competitive advantage have higher than average returns on shareholders’ equity.
- Examples include Coca-cola (30%), Wrigley (24%), Hershey’s (33%), Pepsi (34%), in contrast to American airlines (4%).
The cash flow statement:
Similar to income statements, cash flow statements cover a period of time.
A company can have a lot of cash and not profitable, and vice versa.
Cash flow from operating activities = net income + depreciation + amortization
Cash flow from investing operations = capital expenditures (always negative) + other investing operations (negative or positive)
Cash flow from financing activities = dividends paid + issuance or retirement of stocks + issuance or retirement of bonds
Net change in cash = cash flow from operating activities + cash flow from investing operations + cash flow from financing activities
Capital expenditures:
- Cash spent on assets that are expensed over more than a year through depreciation or amortization (property, plant, equipment, patents…etc.).
- Example: a truck is a capital expenditure, but gas is a current expense.
- Capital expenditures to earnings ratio is generally smaller in companies with a durable competitive advantage.
- Examples include Coca-cola (19%), Wrigley (49%), Moody’s (5%), in contrast to GM (444%), Goodyear (950%).
Key points when studying a company:
Note that all these are rules that can have exceptions.
The income statement:
- Gross profit margin ≥ 40% and avoid high operating expenses.
- Consistent ‘SGA/gross profit’ ratio.
- SGA/gross profit ratio < 30% is fantastic, but there are good companies with a ratio up to 80%.
- Low (or non continuous) R&D costs.
- Low depreciation to gross profit ratio.
- Interest payouts ≤ 15% of operating income.
- Make sure the company’s reported income is consistent with the tax they paid (find on SEC).
- Historical net earnings/total revenue ratio ≥ 20%. Never less than 10%.
- 10-year upward trend of net earnings and per-share earnings.
The balance sheet:
- A lot of current cash and low debt for at least 7 years.
- Inventory that is rising consistently and in parallel with net earnings.
- Lower net receivables/gross sales ratio than competitors.
- Current ratio > 1. Exceptions include companies with strong earning power.
- No ongoing increases in property, plant, and equipment.
- When assessing return on total assets, keep in mind that it sometimes as it gets higher, it indicates a lower competitive advantage.
- Low or no long-term debt. Net earnings enough to pay all long-term debt in 3–4 years.
- Debts to shareholders’ equity ≤ 0.8
- Absence of preferred stocks.
- Annually growing retained net earnings.
- The presence of treasury stocks and a history of buying back shares.
- High returns on shareholders’ equity.
- AVOID businesses that use a lot of leverage to generate earnings.
The cashflow statement:
- Positive cashflow.
- Capital expenditures/net earnings ≤ 25% for 10 years. Never more than 50%.
- A history of buying back stocks.
