Warren Buffett and the Interpretation of Financial Statements

These are personal notes (some copy/pasted), so please don’t judge any grammar! If you see something interesting here, let’s discuss it! 

Warren Buffett and the Interpretation of Financial Statements

Income Statement:

· Companies that consistently have higher gross profit margins have a durable competitive advantage. Warren looks for gross margins higher than 40%. 20% and below indicates a fierce competitive industry (example: airlines).

· The lower a companies SGA expense the better. Anything under 30% of Gross profits is ideal. There have been companies in the past with durable competitive advantages with SGA 30%-80%. When looking at SGA, also look at R&D cost. A high SGA can be justified (but not optimal) with no R&D cost

· R&D: Companies that constantly have to spend huge sums of money to stay competitive are not an attractive company. Pharmaceutical companies and Microsoft are examples of this. High R&D cost eat up a lot of their gross profits and the problems lies in the fact that they have to spend this money to compete, which makes their long term economics unattractive.

· Warren likes depreciation expense to be a very low percent of gross profits. Coke has a 6%, PG 8%, while GM has a 22%-57% of gross profits.

· A low interest expense compared to operating profits is something Warren looks for. Southwest Airlines pays 9% of operating income in interest while its competitor, United, pays 61%. An interest expense of 15% or lower of operating income shows a competitive advantage.

· Warren always looks at pre-tax income to compare investments.

· Look at the taxes a company makes. At the time of this book, corporate tax rates were 35%. If a company does not pay 35% in taxes, chances are they are busy misleading the IRS and will also be busy misleading you as an investor.

· Net earnings should have a historical uptrend. Look at net earnings/Revenue. 20% or higher and you have some sort of competitive advantage. 10% and below are not good investments.

 

Balance Sheet:

· Companies should have a ton of cash and little or no debt. Cash is king in troubled times.

· Companies that sell products that don’t change don’t face an obsolete inventory problem. Warren looks for companies with rising inventories alongside rising net earnings. This implies that a company can fulfill its orders on time as their demand rises.

· A company consistently showing lower Net Receivable to Gross Sales ratio has an advantage over its competitors. Some companies will offer more attractive financing terms to attract business. A great company should now have to do this.

· Current ratio, Total Current Assets/Total Current Liabilities above 1 is what we look for. Many companies that have an extraordinary advantage will have current ratios less than 1 however. This stems from the fact that they can easily cover expenses from their operating business and anything they cannot cover, they can get short term debt financing at attractive terms. Not something Warren uses much.

· PPE: A company with a durable competitive advantage does not need to constituently update and upgrade its PPE to stay competitive. Look for lower PPE all thing equal.

· Goodwill: Companies that have a durable competitive advantage almost never sell for less than book value. When we see goodwill rising on a balance sheet, we assume that the company has been buying. We cannot tell if they overpaid or bought a company with a durable competitive advantage and thus, goodwill is not highly used for Warren.

· Intangible assets: Warren loves to buy a companies name and reputation. Coke was too expensive to be a Graham stock, but Warren knew that Coke’s 100 year reputation was more valuable than others could see.

· Want to see Long Term Investments rising. LT Investments are carried at cost.

· Return on Assets – Higher % can indicate weaker advantage due to lower cost of entry into business. Ex. Coke has 43B in assets with a 12% ROA while Moody’s has 1.7B in assets and a 43% ROA. No one can raise 43B to take on Coke but someone could raise 1.7B to compete with Moody’s. In this instance, more is less.

· A high amount of short term debt, or long term debt coming due, can kill a company. It is possible to roll the debt, raise more short term debt to pay the currently due debt. This works until a financial disaster which can wipe a company out, EX Bear Sterns.

· Companies with a competitive advantage often have little or no long term debt over the last ten years. The company can be self finance itself when needed and does not need to borrow much. Further, a company’s net earnings should be able to pay off all of its long term debt within 3-5 years.

· Total debt to Equity is a measure of whether the company uses debt or equity to finance its operations. We want to see a higher share of Equity and lower share of debt, showing a lower ratio as better. Problem lies that some companies buy back so many shares their Equity appears very low. To modify this, add back treasury stock to equity and then compute the ratio. A modified ratio of .8 or lower is what we look for.

· Preferred shares are not commonly used by a company with a durable competitive advantage. Preferred dividends are not tax deductable and usually care an interest rate higher than comparable debt.

· Retained earnings is the most important number in Warren’s eyes. This is number that shows how much the company is growing by and ultimately keeping for itself. Growth in RE means they are growing their earnings and this is a positive thing for long term success.

· Treasury stock grows when a company buys back their shares. This is something Warren likes. A history of buy backs and treasury shares rising indicates that a company has an advantage and is favorable long term.

Cash Flow Statement:

· Capital Expenditures are outlays of cash that a company needs to undergo to continue operations. A company that has a durable competitive advantage spends less of its earnings on this CapEx than the next. Warren has typically stayed away from telecomm for this reason. Warren uses a 50% or less of their annual capex to Net earnings as his durable competitive advantage ratio.

· Warren prefers to see a company buy back shares than pay a dividend. Buying back shares is a tax free way to increase the shareholder wealth. A history of this buying back shares usually comes with a competitive advantage.

Notes:

· Buying a company with a durable competitive advantage at the wrong price can give you mediocre results for investors. Stay away from high P/E stocks in the height of the bull market.

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