Repository following the book: Warren Buffett and interpretation of financial statements
You have to understand accounting and you have to
understand the nuances of accounting.
It's the language of business and it's an
imprefect 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 Buffet
- How do you identify an exceptional company with a durable competative advantage?
- How do you value a company with a durable competative advantage?
- No longer had to wait for Wall street to serve up a bargain price. Pay a fair price for superbusiness.
- Time will make him superrich when he invests in a company that has a durable competative advantage
- Basis business models of these exceptional companies
- They sell either a unique product or service
- They are low cost buyers and seller of a product or service that the public constantly needs
- The consistency in the product that creates consistency in the company's profits
Financial statements overview: Where the gold is hidden
Financial statements come in three distinct flavours:
- The income statement
- The balance sheet
- Cash flow statement
MSN or Yahoo's Finance web page. All publicly traded companies must file quarterly financial statements and annual reports with the SEC.
You have to read a zillion corporate annual reports and their financial statements.
Warren Buffett
Some men read Playboy. I read annual reports.
Warren Buffett
Income Statement
($ in milions)
Revenue $10,000
> Cost of Goods Sold 3,000
---------------------------------
> Gross Profit 7,000
Operating Expenses
> Selling, General & Admin. 2,100
> R&D 1,000
> Depreciation 700
---------------------------------
> Operating Profit 3,200
> Interest Expenses 200
> Gain(Loss) Sale Assets 1,275
> Other 225
---------------------------------
> Income Before Tax 1,500
> Income Tax Paid 1,525
---------------------------------
> Net Earnings $975
Gross revenue is where the money comes in.
Aka cost of revenue.
Gross Profit / Gross Revenue = Gross Profit Margin
$7000/$1000 = 70%
Companies with durable competative advantage have excelent long term economics tend to have consistently higher gross profit margin than those who don't.
As a very general rule: Companies with Gross profit margin >= 40% tend to have durable competative advantage. Companies below 40% tend to be companies in highly competative industries.
Company expenses associated with R&D of new products, selling and administrative costs, depreciation & amortization, restruturing and impairing charges, all non-recurring and non-operating expenses.
Operating expenses are substracted from the gross profit to give us the operating profit/loss.
Companies that don't have durable competative advantage suffer from intense competition and show wild variation in SGA. The lower SGA the better. There are as well companies with low to medium SGA expenses that destroy long-term business economics with high R&D, capital expenditures, and/or interest expenses on their debt loan.
Companies that gave to spend heavily on R&D have an inherent flaw in their competative advantage that will always put their long-term economics at risk.
All machinery and buildings eventually wear out over time, this wearing out is recognized on the income statement as depreciation.
EBITDA - Earnings before income tax, depreciation and amortization
Companies with durable competative advantage tend to have lower depreciation costs as a percentage of gross profit.
The entry for the interest paid out on the debt the company carries out on the balance sheet as a liability.
Comapnies with durable competative advantage tend to carry out little or no interest expense.
Warren belives they should be removed from any calculation of net earnings in determining whether a company has a durable competative advantage.
It is the income after all expenses are deducted but before income tax has been subtracted.
Companies that are bsy misleading the IRS are usually are usually hard working at misleading their shareholders as well. The beuty of a company with durable competative advantage is that it make so much money that it doesn't have to mislead anyone to look good.
- Are net earning showing a historical upwards trend
- Per share earnings trend might differ from net earnings historical trend due to share repurchase.
Companies with durable competative advantage will report higher percentage of net earnings to total revenue. A general rule is that if a company is showing net earnings history of >= 20% on total revenue there is real good chance that it is benefiting from some kind of long-term competative advantage. One exception for this rule are banks and financial companies.
Net income and divide it by shares outstanding. Warren is looking for a consistency and upward trend in historical records. Eractic earnings are not a good sign.
One of the things you will find which is interesting
and people don't think of it enough with most business and with most individuals is life tends to
snap you at your weakest links. The two biggest weak links in my experiance: I've seen more people
fail because of liquor and leverage - leverage being borrowed money.
Warren Buffett
How much the company has in assets and how much it owes to vendors. Balance sheets reports:
- Assets
- Cash
- Receivables
- Inventory
- Property
- Plant
- Equipment
- Liabilities
- Current (within the year)
- Long term (due in one year or more)
The net worth of the company is equal to the assets minus the liabilities which is the same as the shareholders equity
Balance Sheet
($ in milions)
Assets
Cash & Short term investements $4,208
Total inventory 2,220
Total receivables, net 3,317
Prepaid expenses 2,260
Other current assets, total 0
-------------------------------------
Total current assets 12,005
Property/Plant/Equipments 8,493
Goodwill, net 4,246
Intangibles, net 7,863
Long-term investements 7,777
Other long-term assets 2,675
Other assets 0
-------------------------------------
Total assets $43,059
Liabilities
Account payable $1,380
Accrued expenses 5,535
Short-term debt 5,919
Long-term debt due 133
Other current liabilities 258
-------------------------------------
Total current liabilities 13,225
Long-term debt 3,277
Deferred income tax 1,890
Minority interest 0
Other liabilities 3,133
-------------------------------------
Total liabilities 21,525
Shareholders Equity
Preferred Stock 0
Common Stock 880
Additional paid in capital 7,378
Retained earnings 36,235
Treasury stock - common -23,375
Other equity 626
-------------------------------------
Total Shareholders equity 21,744
Total liabilities &
Shareholders equity $43,269
- Current assets - cash and cash equivalents, short term investements, net receivables, inventory and other
- Long-term assets
A company basically has three ways og generating a large stockpile of cash
- Sell new bonds or equity to the public
- Sell an existing business
- From an ongoing business that generates more than it burns
Check the last seven years to see exatcly what is creating all the cash.
- Look for an invenoty and net earnings on the rise, this indicates that the companyfinds profitable ways to increase sales, that increase in sales has called for increase in the inventory so that the company can fulfill orders in no time
Current ration = Current assets / current liabilities In general a current ration over 1 is considered good but there are many exceptions.
A company with durable competative advantage can fincance new plants and equipments internally. A company that doesn't will be forced to turn to debt to finance its constant need.
ROA = net earnings / total assets
Companies with competative advantage rarely depend on long-term debt to maintain their business operations.
Company should have sufficient yearly net earnings to pay off all of its long-term debt within a three-four years earnings period.
Debt to shareholders equity ratio = Total liabilities / shareholders equity
It is easy to identify companies with durable advantage when we look at the treasury shared-adjusted debt to shareholders equity ratio
Net earnings can be used to paid out as dividents, buy back shares or retained to grow the company.
Retained earnings = Net earnings - (expenditures for buying back shares + paid out dividents)
In theory: the more earnings a company retains the faster it grows its retained earnings pool which in turn will increase growth rate of future retained earnings.
After buying back shares a company can either cancel them or retain them, in case it retains them they are listed on the balance sheet as treasury stocks
The presence of treasury stocks on the balance sheet and a history of buying back shares are a good indicator that the company in question has durable competative advantage.
Net earnings / Shareholders equity = Return on shareholders equity
Companies with durable competative advantage show higher return on shareholders equity
There is a huge difference between business that
grows and requires lots of capital to do so and
the business that grows and doesn't require capital.
Warren Buffett
- Cash flow from operating activities
($ in millions)
Net income $5,981
Depreciation 1,163
Amortization 125
----------------------------
Total Cash from
Operating Activities $7,260
- Cash from investing operations
($ in millions)
Capital Expenditures $1,648
Other Investing
Cash Flow Items 5,071
----------------------------
Total Cash from
Investing Activities $6,719
- Financing Activities
($ in millions)
Cash Dividents Paid $3,149
Issuance(Retirement) of Stock, Net 219
Issuance(Retirement) of Debt, Net 4,341
-------------------------------------------
Total Cash from
Financing Activities $973
If we add Total Cash from Operating, Investing and Financing activities we get the company's net change in cash.
($ in millions)
Total Cash from Operating Activities $7,269
Total Cash from Investing Activities 6,719
Total Cash from Financing Activities 973
-------------------------------------------
Net Change in Cash $1,523
Company with durable competative advantage uses a smaller portion of its earnings for capital expenditures for continuing operations.
Less than 50% of its earnings as capital expenditures - potential durable competative advantage Less than 25% of its earnings as capital expenditures - benefits from durable competative advantage
I look for business in which I think I can predict
what they're going to look line in ten to fifteen years time. Take Wringley's chewing gum. I don't think that the internet is going to hcange how people chew gum.
Warren Buffett
Fantastic companies seldom sell for bargain price by the Grahamian perspective. So when do you buy them? In bear markets.
As general rule we never sell companies with durable competative advantage. If we consider a sale, let it be for one of the following two reasonos:
- financing a purchase of even better company
- in case of a bull market and a great returns now compared to the long term target
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