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The Quality of Business Earnings - Checklist of Questions

October 29, 2013 | About:
The list of 17 questions below can provide valuable qualitative and quantitative evidence during the business research process. Warren Buffett compared investing to reporting when talking to Robert Woodward of The Washington Post.


“Investing is reporting. I told him to imagine an in-depth article about his own paper. He’d ask a lot of questions and dig up a lot of facts. He’d know The Washington Post. And that’s all there is to it.”

“You need a moat in business to protect you from the guy who is going to come along and offer it (your product) for a penny cheaper.”

“If (you go into a store and) they say ‘I don’t have a Hershey bar, but I have this unmarked chocolate bar that the owner of the place recommends,’ if you’ll walk across the street to buy a Hershey bar or if you’ll pay a nickel more for the (Hershey) bar than the unmarked bar or something like that, that’s franchise value.”

“How much more fruitful it is for us to think about whether the product is likely to sustain itself and its economics than to try to be questioning whether to jump in and out of the stock.”

“If I’m thinking about investing in a specific company, I try to size up their business and the people running it. And as I read annual reports, I’m trying to understand generally what’s going on in all kinds of businesses. If we own stock in one company and there are eight others in the industry, I want to be on the mailing list for the annual reports of the other eight because I can’t understand how my company is doing unless I understand what the other eight are doing. I want perspective on market share, margins, the trend in margins – all kinds of things...”

“It’s amazing how well you can do in investing with what I’d call “outside” information. I’m not sure how useful inside information is. But there’s all kinds of “outside” information around as to businesses. And you don’t have to understand all of them. You just have to understand the ones you’re thinking about investing in. And you can. But no one can do it for you.”

“In my view, you can’t read Wall Street reports and get anything out of them. You’ve got to get your arms around it yourself. I don’t think we’ve ever gotten an idea from a Wall Street report. However, we’ve gotten a lot of ideas from annual reports. Charlie?”

Finding the right questions to ask about a business to an employee, manager, customer, competitor or oneself when reading reports, should be approached in a systematic fashion. All the questions should be answered in a "spin-free" manner with no extra jargon, in a clear insightful manner. The key to the process is knowing what you don't know and won't know versus what can be answered with reliability and validity. The list of questions is originally from Appendix C of "Investing for Higher After-Tax Returns" from Tweedy Browne with minor additions made.

“PUCCI”: Pricing, Units, Costs, Competition and Insiders

· What is the outlook for pricing? Adjusted? (Each dollar of price increase will increase pre-tax income by $1.00 if other costs do not increase.)

· Outlook for unit volume? (A 10% increase in units will increase gross profits by 10% if the gross profit margin does not change. Pre-tax income will increase by this amount if other costs do not increase.)

· Outlook for the gross profit margin as a percentage of sales? How much is the gross profit margin expected to increase/decrease as a result of changes in price, mix of business and (or) specific costs that make up cost of goods sold?

· Outlook for selling, general and administrative costs/margin as a percentage of sales? Description of any significant selling, general and administrative cost changes.

· Operating leverage: If sales increase by, say, $10 million, how much will it drop to pre-tax income?

· Outlook for the pre-tax profit margin? Can the pre-tax margin get back to the prior peak margin of_____% attained in year 20XX? Can the pre-tax margin get to_____% that your competitor, _________________________, earns?

· Amount of non-recurring, or investment/expansion-type expenses included in costs? Net assets tied up in these non-core activities? Core recurring profits?

· Segment or product line losses included in the consolidated income statement? Net assets tied up in the loss-producing or break-even activities? Core recurring profits? (For example, if the business is a retail chain with 100 stores, what are the total losses of all the stores that lose money and the total profits of all the stores that make money and the net assets tied up in the losers?)

· After-tax goodwill amortization? (i.e. what is the amount of the tax deductible goodwill amortization and the amount of non-tax deductible goodwill amortization?)

· Are you comfortable with the consensus EPS estimates for the current year of and next year of________?

· Outlook for growth in EPS over the next five years? How will you get the growth/what specifically will you do to get the growth? Return on equity/return on capital goal/outlook over the next five years? How will you get there?

· Over the next five years, what do you plan to do with the cash that will be generated from earnings and not paid out as a dividend? What investments do you plan to make; such as, new factories, additional stores, acquisitions, share buybacks? What return do you expect to earn on planned investments? (Think of a business like a savings account that reinvests the cash earnings that are kept in the business and not paid out as a dividend. The new cash that is invested can earn a new return that can add to the overall earnings of the business.)

· Competitive conditions? Expected changes/actions taken by competitors (such as price changes, new products, new capacity, new marketing programs, etc.) and the expected impact on the subject company’s pricing, units, margins.

· Amount of costs/expenses that would disappear if the company was consolidated with a competitor (such as corporate expense, overlapping duplicate sales outlets or salespersons, manufacturing costs that would disappear if the company’s sales volume was folded into a competitor’s factory)? If the separate businesses owned by the subject company were sold, how much of the subject company’s corporate expense would disappear? (In other words, would the acquirer’s income go up by the amount of segment EBIT that was acquired, or would it have to keep the functions provided by the subject company’s “corporate” activity and the related expense?)

· Rules of thumb/valuation standards such as Price/EBIT (Earnings Before Interest and Taxes),Price/EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), Price/Sales, Price/Acre, Price/Board Foot of Timber, Price/Ton of Capacity, Price/Salesperson, Price/Dollar of Deposits, etc., for similar businesses? What does the company itself think it is worth?

· Does the company plan to buy back stock?

· Have insiders bought or sold stock recently? Describe. Why did he or she buy? Why did he or she sell (if the sale was significant)?

“Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn’t count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.” -- Warren Buffett

About the author:

Tannor Pilatzke
I am a self taught investor through Warren Buffett, Charlie Munger, Ben Graham, Peter Lynch, Joel Greenblatt, David Einhorn, Seth Klarman, Howard Marks, Phillip Fisher and Thornton O'Glove. My focus is a bottoms up Value-GARP strategy with a mix of top down contrarianism.

"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain

Visit Tannor Pilatzke's Website


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