Overview
In part one, I went through how Warren Buffett (Trades, Portfolio) interprets the Income Statements and the Balance Sheet. Now in part two, I'll show you how he goes through Retained Earnings, Treasury Stock and the Cash Flow Statements.
Retained Earnings:
Retained earnings is one of the best ways to indicate if a company has a durable competitive advantage. Companies with durable competitive advantages use net earnings to pay out dividends, buyback share and retain for future growth.
- Companies that don't add to their net worth aren't growing their net worth.
- The rate of growth of retained earnings is a great indicator of a competitive advantages.
- The more earnings a company retains the faster its growth and increases its growth in future earnings.
Treasury Stock:
- Is carried on the balance sheet as a negative value because its represents a deduction in shareholders' equity.
- Companies that have competitive advantages have free cash, this means treasury stock is a hallmark of that durable competitive advantage.
- When companies buyback shares, those shares are held as treasury stock and this means that the company is decreasing the company equity. This results in a higher return on equity.
- High return on equity is a sign of a competitive advantage; however, it's important to know whether it's the result of financial engineering or exceptional business economics.
- To confirm this, take the negative treasury stock, turn it positive, add it to shareholder equity, and then divide it by net earnings to get the return on equity without the window dressing.
Cash Flow Statements:
Capital Expenditures:
Avoid companies that have large capital outlays like the telephone companies. Companies that has a durable competitive advantage will use a smaller portion of its net earnings for capital expenditures. Companies that historically use less than 50% is a good starting point and companies that use less than 25% of net earnings has a durable competitive advantage. To compare capex to net earnings, it's best to add up the last seven years of capex spending and compare it to net earnings over seven years.
Summary Of What Warren Buffett (Trades, Portfolio) Looks For In The Financial Statements:
| Income Statement | (DCA = Durable Competitive Advantage) | Comments |
| Gross Profit Margin | >40% = D.C.A. <40% = competition eroding margins <20% = no sustainable competitive advantage | Consistency is Key |
| SG&A (SGA as % of gross profit) | < 30% is fantastic. Nearing 100% is in highly competitive industry | Consistency is Key |
| Depreciation (depreciation costs as a % of gross profit) | Company with moat tend to have lower % | |
| Interest Expenses (interest expenses relative to operating income) | Durable competitive advantage carry little or no interest expense. Warren Buffett (Trades, Portfolio)'s favorite consumer products have <15% | Company with lowest ratio of interest to Operating Income = competitive advantage. Varies widely between industries. |
| Net Earnings (% net earnings to total revenues) | Net earnings history >20% = Long Term moat < 10% = in highly competitive business | Consistency and upward LT trend |
| EPS | 10-year period showing consistency and upward trend. Avoid erratic earnings pictures. | Consistency = sign products don’t need to change. Upward trend = strong |
| Balance Sheet | ||
| Cash and Equivalents | Lots of cash and marketable securities + little debt | Test to see what is creating cash by looking at past 7 yrs of balance sheets |
| Inventory | Look for an inventory and net earnings that are on a corresponding rise | Inventories that spike up/down are indicative of competitive industries prone to (boom/bust) |
| Net Receivables | Consistently shows lower % net receivables to gross sales than competitors | d.c.a. no need to offer generous credit |
| Goodwill | Increase in goodwill over number of years assume because company out buying companies >BV | d.c.a.’s never sell for less than BV |
| LT Investments | Can have valuable assets on books at valuation < market price (booked at lowest price) | Tells us about investment mindset of management (Looking for d.c.a.?) |
| Intangible Assets | Internally developed brands not reflected on BS | |
| Total Assets + ROA (Measure efficiency using ROA) | Higher return the better (but really high ROA may indicate vulnerability in durability of c.a.) | Capital = barrier to entry |
| ST Debt | Financial institutions. Warren Buffett (Trades, Portfolio) shys from those who are bigger borrowers of ST than LT debt | |
| LT Debt Due | d.c.a. need little or no LT debt to maintain operations | |
| Total CL + Current Ratio | Higher the ratio, the more liquid, the greater its ability to pay CL | d.c.a.’s don’t need ‘liquidity cushion’ so may have <1 |
| LT Debt | LT debt load for last ten yrs. ten yrs w/ little LT debt = d.c.a. | Earning power to pay their LT debt in <3/4 yrs = good candidates |
| Total Liabilities + Treasury Share-Adjusted debt to Shareholder Eq Ratio | If <.80, Good chance company has d.c.a. | |
| Preferred + Common Stock | In search for d.c.a. we look for absence of preferred stock | |
| Retained Earnings | Rate of growth of RE is good indicator | |
| Treasury Stock | Presence of treasury shares and a history of buyback are good indicators that company has d.c.a. | Convert –ve value of treasury shares into +ve and add shareholder eq. Divide net earnings by new shareholders eq. give us return on equity minus dressing. |
| Return on Shareholder equity | d.c.a. show higher than average returns on shareholders equity | If company shows history of strong net earnings, but shows –ve sholder equity, probably d.c.a. because strong companies don’t need to retain |
| Cash Flow Statement | ||
| Capital Expenditures | Historically using <50% then good place to look for d.c.a. <25% probably has d.c.a. | Add up total cap exp for ten-yr period and compare w/ total net earnings over period. |
| Stock Buybacks | Indicator of d.c.a. is a history of repurchasing/retiring its shares | Look at cash from investment activities. “Issuance (Retirement) of Stock, Net |
