Cutting through financial statements can be a truly comprehensive task. How could we go about it more efficiently without missing important information? After some time investing, I have found these shortcuts to be very useful in separating interesting things from mediocre opportunities.
Risks section: After identifying an attractive company, it may be the case that we run into a sector that we don’t have much knowledge of. While it is certain that we can learn anything, it has been demonstrated that even the most successful investors stay inside their circle of competence. So after reading this section, I am usually honest with myself and ask two questions: Did I understand the basics of the industry’s dynamics? Is this sector something I enjoy reading about? If the answer is no, I move on.
I also make myself the questions that you’ll find here to determine if there’s indication of Franchise Value. (Which could make predictions at least reasonable)
“We have no system for estimating the correct value of all businesses. We put almost all in the “too hard” pile and sift through a few easy ones.” Charlie Munger (Trades, Portfolio)
Pre-tax profits: Charlie Munger (Trades, Portfolio) refers to EBITDA as “bullshit” earnings. So go all the way down to pre-tax figures with a question in mind: Are pre-tax profits and margins and yields increasing steadily? This is generally a good indicator, however, there are exceptions when big jumps are present. These could indicate a good opportunity if the reason is temporary/fixable.
“I think that, every time you saw the word EBITDA you should substitute the word "bullshit" earnings.” Charlie Munger (Trades, Portfolio)
CFO and FCF: When earnings are increasing steadily, I like to see them followed by cash flow from operations. Why? Simply because this reflects that the business is managing its working capital properly and receiving cash for goods and services. When there are huge differences, earnings could be aided by investments or extraordinary elements that are not recurrent in nature.
“People want a formula, but it's not that easy. To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. All cash is equal. You just need to evaluate a business's economic characteristics.” Warren Buffett (Trades, Portfolio)
Book Value per share: Compounding machines increase their book value significantly via share repurchases, increasing retained earnings, debt reductions and/or low depreciation on assets. An upward trend is generally a good indication.
Debt Levels: Debt isn’t necessarily bad, as leverage can be helpful in amplifying returns. However, excessive amounts of it measured by the interest coverage ratio (interest expense / EBIT) can be helpful to determine if debt is suffocating the company instead of helping it achieve results.
ROE: Generally high ROEs are accompained by real competitive advantages. A good way to discover the quality of a high ROE margin is to decompose it with DuPont Analysis to see exactly where the company is obtaining benefits from.
After some time investing, I have come to rely on these pillars before deciding to dig deeply into financial statements. If most of these are in place, then it’s time to think about strategy, management, and really understanding how the industry operates, in other words, dig deeply into the company’s statements.
What are your rules of thumb/shortcuts? I would love to share thoughts with you!
