Книга 34. «Warren Buffett and the Interpretation of Financial Statements». Mary Buffett & David Clark.
◼️As you can understand from the title, the book is about tools and techniques that Warren Buffett uses to identify companies that will make him richer.
◼️Here, the authors of the book are clearly explaining how to read financial statements and make investment decisions based on information one collected from financial reports.
◼️The book consists of 5 parts:
• about Buffett’s investment strategy; what kind of companies he likes most
5) Valuing the Company with a Durable Competitive Advantage
• about best time to buy or sell a company; ways to value business.
◼️In order to understand the book you need to have basic knowledge of finance and accounting. At least, be familiar with income statement, balance sheet and cash flow and components of those financial statements.
◼️I will highly recommend to read this book for:
• students studying finance and economics
• those who are interested in investing
• people working in finance sphere
This book will teach you how to read company’s financial statement using the unique set of Warren Buffet’s tools for uncovering profitable businesses.
"You have to understand accounting and you have to understand the nuances of accounting. It's the language of business and it's an imperfect language, but unless you are willing to put in the effort to learn accounting how to read and interpret financial statements- you really shouldn't select stocks yourself." WARREN BUFFETT
CHAPTER #1: Two revelations of Warren Buffett that made him the Richest person in the world:
The purpose of this book is to explore Warren's two revelations:
1. How do you identify an exceptional company with a durable competitive advantage?
2. How do you value a company with a durable competitive advantage?
CHAPTER #2: The kind of Business that Will Make Warren Superrich.
The story of Buffet's mentor and father of value investing Benjamin Graham.
In the early 1930s an enterprising young analyst on Wall Street by the name of Benjamin Graham noticed that the vast majority of hotshot stock pickers on Wall Street didn't care at all about the long- term economics of the businesses that they were busy buying and selling. All they cared about was whether the stock prices, over the short run, were going up or down.
Graham noticed that hotshots would sometimes send stock prices spiraling to insane lows that similarly ignored the businesses' long-term prospects.
It was in these insane lows that Graham saw a fantastic opportunity to make money. Graham reasoned that if he bought these" oversold businesses" at prices below their long-term intrinsic value, eventually the market would acknowledge its mistake and revalue them upward. Once they were revalued upward, he could sell them at a profit. This is the basis for what we know today as value investing. Graham was the father of it. What we have to realize, however, is that Graham really didn't care about what kind of business he was buying.
Buffett follows the Benjamin Graham school of value investing, which looks for securities whose prices are unjustifiably low based on their intrinsic worth. Rather than focus on supply and demand intricacies of the stock market, Buffett looks at companies as a whole.
Value investing is the art of buying stocks which trade at a significant discount to their intrinsic value. Value investors achieve this by looking for companies on cheap valuation metrics, typically low multiples of their profits or assets, for reasons which are not justified over the longer term.
What kind of companies Buffet likes?
He likes " superstars" that are benefited from some kind of competitive advantage that created monopoly- like economics, allowing them either to charge more or to sell more of their products. In the process, they made a ton more money than their competitors. Warren also 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. Given a continuing increase in the underlying value of the business, it made more sense for Warren to keep the investment as long as he could, giving him a greater opportunity to profit from the company's competitive advantage.
Warren also noticed that Wall Street- via the value investors or speculators, or a combination of both- would at some point in the future acknowledge the increase in the underlying value of the company and push its stock price upward.
There was something else that Warren found even more financially magical. Because these businesses had such incredible business economics working in their favor, there was zero chance of them ever going into bankruptcy.
Benefit of long-term investment
Buffett realized that if he held the investment long-term, and he never sold it, he could effectively defer the capital gains tax out into the far distant future, allowing his investment to compound tax- free year after year as long as he held it.
Let's look at an example: In 1973 Warren invested$ 11 million in The Washington Post Company, a newspaper with durable competitive advantage. Over the thirty- five years he has held this investment, its worth has grown to an astronomical $ 1.4 billion. Invest $ 11 million and make $ 1.4 billion! Not too shabby, and the best part is that because Warren has never sold a single share, he still has yet to pay a dime of tax on any of his profits.
CHAPTER #3: Where Warren Starts His Search for the Exceptional Company.
Before we start looking for the company that will make us rich, which is a company with a durable competitive advantage, it helps if we know where to look.
Warren has figured out that these super companies come in three basic business models:
1. They sell either a unique product or a unique service
2. They are the low-cost buyer and seller of a product
3. They provide service that the public consistently needs.
CHAPTER #4: Durability is Warren's Ticket to Riches.
Warren has learned that it is the" durability" of the competitive advantage that creates all the wealth.
Coca-Cola has been selling the same product for the last 122 years, and chances are good that it will be selling the same product for the next 122 years.
It is this consistency in the product that creates consistency in the company's profits. If the company doesn't have to keep changing its product, it won't have to spend millions on research and development, nor will it have to spend billions retooling its plant to manufacture next year's model.
Which means that it doesn't have to carry a lot of debt, which means that it doesn't have to pay a lot in interest, which means that it ends up with lots of money to either expand its operations or buy back its stock, which will drive up earnings and the price of the company's stock- which makes shareholders richer.
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 a consistent growth in earnings?
It is this" consistency" that shows up on the financial statement that gives Warren notice of the" durability" of the company's competitive advantage.
CHAPTER #5: Financial Statement Overview: Where the Gold is Hidden.
Financial statements come in three distinct flavors:
First, there is the Income Statement:
The income statement tells us how much money the company earned during a set period of time.
The company's accountants traditionally generate income statements for shareholders to see for each three month period during the fiscal year and for the whole fiscal year.
Using the Income Statement, Warren can determine such things:
3) the consistency and direction of its earnings.
The second flavor is the Balance Sheet:
The balance sheet tells us how much money the company has in the bank and how much money it owes.
Subtract the money owed from the money in the bank and we get the net worth of the company.
Traditionally, companies generate a balance sheet for shareholders to see at the end of each three-month period of time ( called quarter) and at the end of the accounting or fiscal year.
Warren has learned to use some of the entries on the balance sheet such as
1) the amount of cash the company has
2) the amount of long-term debt it carries
as indicators of the presence of a durable competitive advantage.
Third, there is the Cash Flow Statement:
The cash flow statement tracks the cash that flows in and out of the business.
The cash flow statement is good for seeing
1) how much money the company is spending on capital improvements
2) It also tracks bond and stock sales and repurchases.
In the chapters ahead we shall explore in detail the income statement, balance sheet, and cash flow statement entries and indicators that Warren uses to discover whether or not the company in question has a durable competitive advantage that will make him rich over the long run.
CHAPTER #6: Where Warren Goes to Find Financial Information
In the modern age of the Internet there are dozens of places where one can easily find a company's financial statements.
The easiest access is through either
1) MSN.com (http:// money central.msn.com/investor/home.asp)
2) Yahoo's Finance web page (www.finance.yahoo.com).
THE INCOME STATEMENT
"You have to read a zillion corporate annual reports and their financial statements."
"Some men read Playboy. I read annual reports."
An income statement has three basic components:
First, there is the revenue of the business. Then there is the firm's expenses, which are subtracted from the firm's revenue and tell us whether the company earned a profit or had a loss.
1) Revenue.
The first line on the income statement is always total, or gross, revenue. This is the amount of money that came into the business.
Now the fact that a company has a lot of revenue doesn't mean that it is earning a profit. To determine if a company is earning a profit, you need to deduct the expenses of the business from its total revenues. Total revenue minus expenses equals net earnings.
2) Cost of Goods Sold: For Warren the Lower the Better
On the income statement, right under the line for Total Revenue comes the Cost of Goods Sold, also known as the Cost of Revenue.
The cost of goods sold is either the cost of purchasing the goods the company is reselling or the cost of the materials and labor used in manufacturing the products it is selling.
"Cost of revenue" is usually used in place of" cost of goods sold" if the company is in the business of providing services.
Although the cost of goods sold, as a lone number, doesn't tell us much about whether the company has a durable competitive advantage or not, it is essential in determining the Gross Profit of the business, which is a key number that helps Warren determine whether or not the company has a long term competitive advantage. We discuss this further in the next chapter.
3) Gross Profit/Gross Profit Margin: Key Numbers for Warren in His Search for Long-Term Gold
Gross profit is how much money the company made off of total revenue after subtracting the costs of the raw goods and the labor used to make the goods.
It doesn't include such categories as sales and administrative costs, depreciation, and the interest costs of running the business.
By itself, gross profit tells us very little, but we can use this number to calculate the company's gross profit margin, which can tell us a lot about the economic nature of the company.
The equation for determining gross profit margin is:
Gross Profit : Total Revenues = Gross Profit Margin
As a very general rule (and there are some exceptions) companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage.
Companies with gross profit margins below 40% tend to be companies in highly competitive industries, where is hurting overall profit margins (there are exceptions, too).
Any gross profit margin of 20% and below is usually a good indicator of a fiercely competitive industry, where no company can create sustainable competitive advantage over tge competition.
What creates a high gross profit margin is the company's durable competitive advantage, which allows it the freedom to price the products and services it sells well in excess of its cost of goods sold. Without a competitive advantage, companies have to compete by lowering the price of the product or service they are selling. That drop, of course, lowers their profit margins and therefore their profitability.
Let me show you: The gross profit margins of companies that Warren has already identified as having a durable competitive advantage include:
1) Coca- Cola, which shows a consistent gross profit margin of 60% or better;
2) The bond rating company Moody's, 73%;
3) The Burlington Northern Santa Fe Railway, 61%;
4) The very chewable Wrigley Co., 51%;
Contrast these excellent businesses with several companies we know that have poor long-term economics, such as the
1) In- and- out- of- bankruptcy United Airlines, 14%;
2) Troubled auto maker General Motors, 21%;
3) The once trouble, but now profitable U.S. Steel, 17%;
In the tech-world a field Warren stays away from because he doesn't understand it- Microsoft shows a consistent profit margin of 79%, while Apple Inc. comes in at 33%. These percentages indicate that Microsoft produces better economics selling operating systems and software than Apple does selling hardware and services.
4) Operating Expenses: Selling, General & Administrative Expenses(SGA)
In SGA expenses company reports its costs for direct and indirect selling expenses and all general and administrative expenses. These include management salaries, advertising, travel costs, legal fees, commissions, all payroll costs, and the like.
As a percentage of gross profit, they vary greatly from business to business.
Coca Cola consistently spends on average 59% of its gross profit on SGA expenses. A company like Moody's consistently spends on average 25%, and Procter& Gamble consistently spends right around 61%.
"Consistently" is the key word. Companies that don't have a durable competitive advantage suffer from intense competition and show wild variation in SGA costs as a percentage of gross profit.
GM, over the last five years, has gone from spending 28% to 83% of its gross profits on SGA costs. Ford, over the last five years, has been spending 89% to 780% of its gross profits on SGA expenses, which means that they are losing money like crazy.
If the company can't cut SGA costs fast enough, they start eating into more and more of the company's gross profits. In the search for a company with a durable competitive advantage the lower the company's SGA expenses, the better. If they can stay consistently low, all the better.
In the world of business anything under 30% is considered fantastic. However, there are a number of companies with a durable competitive advantage that have SGA expenses in the 30% to 80% range. But 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.
Warren has learned to steer clear and avoid of companies cursed with consistently high SGA expenses
5) Operating Expenses: Research&Development
This is a big one in the game of identifying companies with a durable competitive advantage.
If the competitive advantage is created by a patent, as with the pharmaceutical companies, at some point in time that patent will expire and the company's competitive advantage will disappear.
If the competitive advantage is the result of some technological advancement, there is always the threat that newer technology will replace it. This is why Microsoft is so afraid of the technological advancements of Google.
Not only must these companies spend huge sums of money on R&D, but because they are constantly having to invent new products they must also redesign and update their sales programs, which means that they also have to spend heavily on selling and administrative costs.
Intel, while the leader in its fast-paced field, must consistently spend approximately 30% of its gross profit on R&D expenses ; if it doesn't, it will lose its competitive advantage within just a few years.
Moody's, the bond rating company, is a long-time Warren favorite, with good reason. Moody's has no R&D expense, and on average spends only 25% of its gross profit on SGA expenses.
Coca-Cola, which also has no R&D costs, but has to advertise like crazy, still, on average, spends only 59% of its gross profit on SGA costs.
Warren's rule: 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.
And if it is not a sure thing, Warren is not interested.
6) Operating Expenses: Depreciation
All machinery and buildings eventually wear out over time ; this wearing out is recognized on the income statement as depreciation.
An example: Imagine that a million-dollar printing press is bought by XYZ Printing Corporation. This printing press has a life span of ten years. We would emphasise that the million-dollar expense for the printing press is not taken in the year that it is bought ; rather it is allocated as a depreciation expense to the income statement, in $ 100,000 increments, over a ten-year period.
What Warren has discovered is that companies that have a durable competitive advantage tend to have lower depreciation costs as a percentage of gross profit than companies that have to suffer the woes of intense competition.
As an example, Coca- Cola's depreciation expense consistently runs about 6% of its gross profits, and Wrigley's, another durable competitive advantage holder, also runs around 7%.
Contrast the case of GM, which is in a highly competitive capital-intensive business. Its depreciation expense runs anywhere from 22% to 57% of its gross profits.
7) Interest Expense
Interest Expense is the entry for the interest paid out, during the quarter or year, on the debt the company carries on its balance sheet as a liability.
The more debt company has, the more it has to pay.
What Warren has figured out is that companies with a durable competitive advantage often carry little or no interest expense.
Long- term competitive advantage holder Procter&Gamble has to pay a mere 8% of its operating income out in interest costs ; the Wrigley Co. has to pay an average 7%
Contrast those two companies with Goodyear, which is in the highly competitive and capital-intensive tire business. Goodyear has to pay, on average, 49% of its operating income out in interest payments.
Even in highly competitive businesses like the airline industry, the amount of the operating income paid out in interest can be used to identify companies with a competitive advantage.
The consistently profitable Southwest Airlines pays just 9% of operating income in interest payments, while its in-and-out-of-bankruptcy competitor United Airlines pays 61% of its operating income out in interest payments. Southwest's other troubled competitor, American Airlines, pays a whopping 92% of its operating income out in interest payments.
As a rule, Warren's favorite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income.
But be aware that the percentage of interest payments to operating income varies greatly from industry to industry.
As an example: Wells Fargo, a bank in which Warren owns a 14% stake, pays out approximately 30% of its operating income in interest payments, which seems high compared with Coke's, but actually the bank is out of America's top five, the one with the lowest and most attractive ratio. Wells Fargo is also the only one with a AAA rating from Standard& Poor's.
The ratio of interest payments to operating income can also be very informative as to the level of economic danger that a company is in. Take the investment banking business, which on average makes interest payments of 70% of its operating income.
The rule here is real simple: In any given industry the company with the lowest ratio of interest payments to operating income is usually the company most likely to have the competitive advantage.
8) Net Earnings: What Warren is Looking For
After all the expenses and taxes have been deducted from a company's revenue, we get the company's net earnings.
There are a couple of concepts that Warren uses when he looks at this number that help him determine whether the company has a durable competitive advantage.
First on Warren's list is whether or not the net earnings are showing a historical upward trend. A single year's entry for net earnings is worthless to Warren.
But note: Because of share repurchase programs it is possible that a company's historical net earnings trend may be different from its historical per-share earnings trend. Share repurchase programs will increase per-share earnings by decreasing the number of shares outstanding. If a company reduces the number of shares outstanding, it will decrease the number of shares being used to divide the company's net earnings, which in turn increases per-share earnings even though actual net earnings haven't increased.
Though most financial analysis focuses on a company's per-share earnings, Warren looks at the business's net earnings to see what is actually going on.
What he has learned is that companies with a durable competitive advantage will report a higher percentage of net earnings to total revenues than their competitors will.
Warren has said that given the choice between owning a company that is earning $2 billion on $10 billion in total revenue, or a company earning $5 billion on $100 billion in total revenue, he would choose the company earning the $2 billion. This is because the company with $2 billion in net earnings is earn a hing 20% on total revenues, while the company earning $5 billion is earning only 5% on total revenues.
So, while the total revenue number alone tells us very little about the economics of the business, its ratio to net earnings can tell us a lot about the economics of the business compared with other businesses.
A fantastic business like Coca- Cola earns 21% on total revenues, and the amazing Moody's earns 31%, which reflects these companies' superior underlying business economics. But a company like Southwest Airlines earns a meager 7%, which reflects the highly competitive nature of the airline business.
In contrast, General Motors, in even a great year-when it isn't losing money- earns only 3% on total revenue. This is indicative of the lousy economics inherent in the supercompetitive auto industry.
A simple rule (and there are exceptions) is that if a company is showing a net earnings history of more than 20% total revenues, there is a real good chance that it is benefiting from some kind of long- term competitive advantage.
Likewise, if a company is consistently showing net earnings under 10% on total revenues it is- more likely than not- in a highly competitive business in which no one company holds a durable competitive advantage.
This of course leaves an enormous gray area of companies that earn between 10% and 20% on total revenue, which is just packed with businesses ripe for mining long- term investment gold that no one has yet discovered.
One of the exceptions to this rule is banks and financial companies, where an abnormally high ratio of net earnings to total revenues usually means a slacking- off in the risk management department.
9) Per-Share earnings
Per-share earnings are the net earnings of the company on a per-share basis. This is a big number in the world of investing because, as a rule, the more a company earns per share the higher its stock price is. To determine the company's per-share earnings we take the amount of net income the company earned and divide it by the number of shares it has outstanding.
As an example: If a company had net earnings of $10 million for the year, and it has one million shares outstanding, it would have per-share earn ings for the year of $10 a share.
While no one yearly per-share figure can be used to identify a company with a durable competitive advantage, a per share earnings figure for a ten-year period can give us a very clear picture of whether the company has a long-term competitive advantage working in its favor. What Warren looks for is a per-share earning picture over a ten-year period that shows consistency and an upward trend. Something that looks like this:
Consistent earnings are usually a sign that the company is selling a product or mix of products that don't need to go through the expensive process of change. The upward trend in earnings means that the company's economics are strong enough to allow it either to make the expenditures to increase market share through advertising or expansion, or to use financial engineering like stock buybacks
The companies that Warren stays away from have an erratic earnings picture that looks like this:
This shows a downward trend, punctuated by losses, which tells Warren that this company is in a fiercely competitive industry.
THE BALANCE SHEET
One of the first things Warren does when he is trying to figure out if a company has a durable competitive advantage or not is to go and see how much the company has in assets think-cash and property-and how much money it owes to vendors, the banks, and the bondholders. To do this, he looks at the company's balance sheet.
Balance sheets, unlike income statements, are only for a set date. We can create a balance sheet for any day of the year. A company's accounting department will generate a balance sheet at the end of each fiscal quarter.
Now a balance sheet is broken into two parts: The first part is all the assets, and there are many different kinds of assets. They include cash, receivables, inventory, property, plant, and equipment.
The second part of the balance sheet is liabilities and shareholder equity.
Under liabilities we find two different categories of liabilities:
"Current liabilities" means the money that is owed within the year, which includes
•Accounts Payable
•Accrued Expenses
•Short Term Debt
• Long- Term Debt.
"Long-term liabilities" are those that come due in one year or more, and include
• unpaid taxes
Now if we take all the assets and subtract all the liabilities, we will get the net worth of the business, which is the same as shareholders' equity.
Assets = Liabilities + Net Worth or Shareholders' Equity
Assets
This is where all the goodies are kept: the cash, the plant and equipment, the patents, and all the stuff that riches are made of. They are found on the company's balance sheet under the heading Assets.
1) "cash and cash equivalents"
These are called current assets because they are cash, or they can be or will be converted into cash in a very short period of time(usually within a year). As a rule ; they are listed on the balance sheet in order of their liquidity(which means how quickly they can be turned into cash).
All other assets are those that aren't current, which means that they will not or cannot be converted into cash in the year ahead.
8) Deferred Long Term Asset Charges.
So let's take a look at the categories and see how we can use them individually and collectively to help us identify the exceptional business with a long-term competitive advantage working in its favor.
1) Cash and Cash Equivalents
One of the first things Warren does is to look at the assets to see how much cash and cash equivalents(highly liquid assets) a company has.
A high number for cash or cash equivalents tells Warren one of two things:
1) that a company has a competitive advantage that is generating tons of cash, which is a good thing
2) or that it has just sold a business or a ton of bonds, which may not be a good thing.
A low amount or the lack of a stockpile of cash usually means that the company has poor or mediocre economics.
A company basically has three ways of creating a large stockpile of cash.
1) It can sell new bonds or equity to the public, which creates a stockpile of cash
2) It can also sell an existing business or other assets that the company owns, which can also create a stockpile of cash
3) Or it has an ongoing business that generates more cash than the business burns.
This 3rd scenario of a large stockpile of cash created by an ongoing business that really grabs Warren's attention.
Because a company that has a surplus of cash as the result of ongoing business is often a company that has some kind of durable competitive advantage working in its favor.
If we see a lot of cash and marketable securities and little or no debt, chances are very good that the business will sail on through the troubled times. But if the company is hurting for cash and is sitting on a mountain of debt, it probably is a sinking ship that not even the skilled manager can save.
A simple test to see exactly what is creating all the cash is to look at the past seven years of balance sheets. This will reveal whether the cash hoard was created by a one-time event, such as the sale of new bonds or shares, or the sale of an asset or an existing business, or whether it was created by ongoing business operations.
If we see lots of debt, we probably aren't dealing with an exceptional business.
But if we see a ton of cash piling up and little or no debt, and no sales of new shares or assets, and we also note a history of consistent earnings, we're probably seeing an excellent business with the durable competitive advantage that Warren is searching for the kind of company that will make us rich over the long-term.
2) Assets: Receivables; Inventory; Prepaid Expences
They tell very little about the company's long-term competitive advantage, but can tell a great deal about different companies within the same industry.
3) Total Current Assets; Current Ratio is useless
Total Current Assets is a number that has long played an important role in financial analysis. Analysts developed the current ratio, which is derived by dividing current assets by current liabilities; the higher the ratio is, the more liquid the company.
A current ratio of over one is considered good, and anything below one bad. If it is below one, it is believed that the company may have a hard time meeting its short-term obligations to its creditors.
The funny thing about a lot of companies with a durable competitive advantage is that quite often their current ratio is below the magical one. Moody's comes in at 0.64, Coca Cola at 0.95, Procter& Gamble at 0.82.
Such companies create an anomaly that renders the current ratio almost useless in helping us identify whether or not a company has a durable competitive advantage.
4) Assets: Property, Plant, and Equipment: For Warren Not Having Them Can Be A Good Thing
Companies that don't have a long-term competitive advantage are faced with constant competition, which means they constantly have to update their manufacturing facilities to try to stay competitive, often before such equipment is worn out. This, of course, creates an ongoing hat is often quite substantial, and keeps adding to the amount of plant and equipment the company lists on its balance sheet. A company that has a durable competitive advantage doesn't need to constantly upgrade its plant and equipment to stay competitive.
We see this when we take a company with a long-term competitive advantage like Wrigley, which has plant and equipment worth $1.4 billion, carries $1 billion in debt, and earns in the neighborhood of $500 million per year.
Compare Wrigley with a company without a durable competitive advantage, like GM, which has plant and equipment valued at $56 billion, carries $40 billion in debt, and has lost money for the last two years. Chewing gum is not a product that changes much, and Wrigley's brand name ensures a competitive advantage over its rivals. But GM must compete head-on with every car manufacturer on the planet, and its product mix constantly has to be upgraded and redesigned to stay ahead of the competition. This means that GM's plants have to regularly be retooled to produce the new products. 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.
Liabilities
Accounts Payable, Accrued Expences and Other Debts cannot tell much about long-term competetive advantage of a company.
Short-term Debts
When it comes to investing in financial institutions Warren has always shied away from companies that are bigger borrowers of short-term money than of long-term money.
Warren's favorite, Wells Fargo, has 57 cents of short-term debt for dollar of long- term debt. But an aggressive bank, like every Bank of America N.A., has $2.09 of short-term debt for every dollar of long-term debt. And while being aggressive can mean making lots of money over the short-term, it has often led to financial disasters over the long-term. And one never gets rich being on the downside of a financial disaster.
Long-Term Debts
Warren has learned that companies that have a durable competitive advantage often carry little or no long- term debt on their balance sheets. This is because these companies are so profitable that they are self- financing when they need to expand the business or make acquisitions, so there is never a need to borrow large sums of money. One of the ways to help us identify the exceptional business, then, is to check how much long- term debt it is carrying on its balance sheet. We are not just interested in the current year ; we want to look at the long- term debt load that the company has been carrying for the last ten years.
Warren's historic purchases indicate that on any given year the company should have sufficient yearly net earnings to pay off all of its long-term debt within a three-or four-year earnings period.
Long-term competitive advantage holders Coca Cola and Moody's could pay off all their long-term debt in a year ; and Wrigley and The Washington Post companies single can do it in two.
But companies like GM or Ford, both in the highly competitive auto industry, could spend every dime of net profit they have earned in the last ten years and still not pay off the massive amount of long-term debt they carry on their balance sheets.
The bottom line here is that companies that have enough earning power to pay off their long-term debt in under three or four years are good candidates in our search for the excellent business with a long-term competitive advantage.
Look whether company has Preffered Stocks or not
The odd thing about preferred stock is that companies that have a durable competitive advantage tend not to have any. The dividends paid on preferred stock are not deductible, which tends to make issuing preferred shares very expensive money. Because it is expensive money, companies like to stay away from it if they can. So one of the markers we look for in our search for a company with a durable competitive advantage is the absence of preferred stock in its capital structure.
Retained Earnings: Warren's Secret for Getting Superrich
At the end of the day, a company's net earnings can either be paid out as dividends or used to buy back the company's shares, or they can be retained to keep the business growing.
When they are retained in the business, they are added to an account on the balance sheet, under shareholders' equity, called retained earnings. If the earnings are retained and profitably put to use, they can greatly improve the long- term economic picture of the business.
It was Warren's policy of retaining 100% of Berkshire's net earnings that helped drive its shareholders' equity from $19 a share in 1965 to $78,000 a share in 2007.
In 2007 Coca-Cola had after-tax net earnings of $5.9 billion and paid out in dividends and stock buybacks $3.1 billion. This gave the company approximately $2.8 billion in earnings, which were added to the retained earnings pool.
Retained Earnings is an accumulated number, which means that each year's new retained earnings are added to the total of accumulated retained earnings from all prior years.
Out of all the numbers on a balance sheet that can help us determine whether the company has a durable competitive advantage, this is one of the most important. It is important in that if a company is not making additions to its retained earnings, it is not growing its net worth. If it not growing its net worth, it is unlikely to make any of us superrich over the long run.
Coca-Cola has been growing its retained earnings pool for the last five years at an annual rate of 7.9%, Wrigley at a very chewy 10.9%, Burlington Northern Santa Fe Railway at a smoking 15.6%, and Warren's very own Berkshire hathaway at an outstanding 23%.
Even more interesting is the fact that both General Motors and Microsoft show negative retained earnings. General Motors shows a negative number because of the poor economics of the auto business, which causes the company to lose billions. Microsoft shows a negative number because it decided that its economic engine is so powerful that it doesn't need to retain the massive amount of capital it has collected over the years and has instead chosen to spend its accumulated retained earnings and more on stock buybacks and dividend payments to its shareholders.
One of the great secrets of Warren's success with Berkshire hathaway is that he stopped its dividend payments the day that he took control of the company. This allowed 100% of the company's yearly net earnings to be added into the retained earnings pool. As opportunities showed up, he invested the company's retained earnings in businesses that earned even more money, and that money was all added back into the retained earnings pool and eventually invested in even more money- making operations.
Treasury Stocks
The presence of treasury shares on the balance sheet, and a history of buying back shares, are good indicators that the company has a durable competitive advantage working in its favor.
Return on Shareholders’ Equity
Financial analysts developed the return on shareholders' equity equation to test management's efficiency in allocating the shareholders' money. This is an equation that Warren puts great stock in, in his search for the company with a durable competitive advantage.
Calculation: Net Earnings divided by Shareholders' Equity equals Return on Shareholders' Equity.
What Warren discovered is that companies that benefit from a durable or long-term competitive advantage show higher-than-average returns on shareholders' equity.
Warren's favorite, Coca-Cola, shows a return on shareholders' equity of 30% ; Wrigley comes in at 24% and Pepsi measures in at 34%.
United Airlines, in a year that it makes money, comes in at 15%, and American Airlines earns 4%.
So here is the rule: high returns on shareholders' equity means "come play." Low returns on shareholders' equity mean "stay away."
Leverage
Leverage is the use of debt to increase the earnings of the company. The company borrows $100 million at 7% and puts that money to work, where it earns 12%. This means that it is earning 5% in excess of its capital costs. The result is that $5 million is brought to the bottom line, which increases earnings and return on equity.
In assessing the quality and durability of a company's competitive advantage, Warren has learned to avoid businesses that use a lot of leverage to help them generate earnings.
THE CASH FLOW STATEMENT
Capital Expenditure
As a rule, a company with a durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a competitive advantage.
When we look at capital expenditures in relation to net earnings we simply add up a company's total capital expenditures for a ten-year period and compare the figure with the company's total net earnings for the same ten-year period.
The reason we look at a ten-year period is that it gives us a really good long-term perspective as to what is going on with the business.
For instance, Wrigley annually uses approximately 49% of its net earnings for capital expenditures. Procter& Gamble, 28% ; Pepsico, 36%; Coca- Cola, 19% ; and Moody's, 5%.
Warren has discovered that if a company is historically using 50% or less of its annual net earnings for capital expenditures, it is a good place to look for a durable competitive advantage.
If it is consistently using less than 25% of its net earnings for capital expenditures, that scenario occurs more than likely because the company has a durable competitive advantage working in its favor.
STOCK BUYBACKS: WARREN'S TAX-FREE WAY TO INCREASE SHAREHOLDER WEALTH
Companies that have durable competitive advantage make a ton of money.
They can either it out as dividends to their shareholders or use it to buy back shares.
Since shareholders have to pay income tax on the dividends, Warren has never been too fond of using dividends to increase shareholders' wealth.
A neater trick that Warren loves is to use some of the excess money that the company is throwing off to buy back the company's shares.
This reduces the number of outstanding shares which increases the remaining shareholders' interest in the company and increases the per-share earnings of the which eventually makes the stock price go up.
More shares outstanding means lower per-share earnings(P/E), and lower shares outstanding means higher per share earnings.
The best part is that there is an increase in the shareholders' wealth that they don't have to pay taxes on until they sell their stock.
To find out if a company is buying back its shares:
Go to the cash flow statement=> look under Cash from Investing Activities =>find heading titled "Issuance (Retirement) of Stock, Net."
This entry nets out the selling and buying back of the company's shares. If the company is buying back its shares year after year, it is a good bet that it is a durable competitive advantage that is generating all the extra cash that allows it to do so.
HOW WARREN DETERMINES TIME TO SELL
In Warren's world you would never sell one of these wonderful businesses as long as it maintained its durable competitive advantage.
The simple reason is that the longer you hold on to them, the better you do. Also, if at any time you sold one these great investments, you would be inviting the taxman to the party.
Consider this: Warren's company has about $36 billion in capital gains from his investments in companies that have durable competitive advantages.This is wealth he hasn't yet paid a dime of tax on, and if he has it his way, he never will.
Still, there are times that it is advantageous to sell one of these wonderful businesses.
1) When need money to make an investment in an even better company at a better price, which occasionally happens.
2) When the company looks like it is going lose its durable competitive advantage.
This happens periodically, as with newspapers and television stations. Both of them used to be fantastic businesses. But the Internet came along and suddenly the durability of their competitive advantage was called into question.
3) During bull markets when the stock market sends the prices on these fantastic businesses through the ceiling. In these cases, the current selling price of the company's stock far exceeds the long term economic realities of the business.