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I just finished "Warren Buffett and the Interpretation of Financial Statements" (thanks for the recommendation, Aaron!) and I wanted to share some notes I made while I was reading. I'll keep the commentary minimal and basically paraphrase what the authors, Mary Buffett and David Clark, say about how Warren looks at financial statements. (By the way, Mary is Buffett's daughter-in-law and David is an old student and self-proclaimed Buffettologist.)

The main idea of the book is to use a company's financials to determine whether it has what Warren calls a "durable competitive advantage." Companies that have a durable competitive advantage benefit from "monopoly-like economics, allowing them either to charge more or to sell more of their products. In the process, they [make] a ton more money than their competitors... if a company's competitive advantage could be maintained for a long-period of time - if it was "durable" - then the underlying value of the business would increase year after year." (page 8)

Buffett's strategy is to find companies with a durable competitive advantage (they use the term a lot, so I'll refer to it as a DCA) and to hold them for decades because the business itself is constantly increasing in value, and sooner or later the stock market realizes that and the stock price adjusts accordingly. The book is organized by the parts of each financial statement, so I'll start where they started, with the income statement. These are some of the more prominent numbers on the income statement that can help determine the presence or absence of a DCA.

- Gross margin: If a company has consistently higher gross margins than its competitors (the book says 40% or higher as a general rule), it means the company doesn't have to worry about fierce competition from other companies in the industry and it probably controls a large part of the market for its products.

- Selling, General, & Administrative (SG&A) Expenses: Look for companies whose SG&A costs are consistently low as a percentage of gross profit (30% or less is ideal).

- Research & Development Expense: Surprisingly, Buffett looks for companies that spend very little or nothing on R&D. The reason he does so is because companies that spend a lot on R&D are not only burning up a big chunk of their gross profit but also always in danger of losing their DCA. The authors used the pharmaceutical and tech industries as examples. Companies in those industries, even dominant companies, must always be the first one to make the next big research breakthrough in order to maintain their advantage. As soon as a competitor comes out with a technologically superior product, the competitive advantage disappears. In short, companies in R&D-intensive industries must always live with the possibility of their products becoming obsolete.

- Depreciation Expense: Find companies who spend less of their gross profit on depreciation than their competitors. While depreciation is not an actual cash expense, in the long run it cuts into gross profit in the form of capital expenditures. Companies with low depreciation/gross profit ratios are typically in less competitive and capital-intensive industries, which is a good thing when looking for DCA.

- Interest expense: Low interest expense is good, because it means the company doesn't rely as much on debt. A good way to compare a company's interest expense to that of competitors is by measuring it as a percentage of operating profit.

- Net Income: Companies with a DCA show a consistent upward trend in net earnings. Dips in the trend are okay, but net income shouldn't fluctuate wildly.

- Profit Margin: Because companies with a DCA are usually able to charge a higher price for their products than competitors, they have wider profit margins than competitors as well. While there are exceptions, the authors recommend looking for companies with profit margins upwards of 20%. If the profit margin is less than 10%, the company is probably facing strong competition and doesn't have a DCA. Between 10% and 20% is a gray area; it's not ideal, but a company can still have a DCA and be in that range. NOTE: Unusually high profit margins in financial companies may mean that the company is taking on too much risk in the form of leverage or risky loans. The numbers look great now, but in the long run it could be dangerous to the company's health.

Those were the most prominent points I took away from the section on the income statement. If I didn't explain the rationale behind any of the standards well enough, let me know. Aaron, I know you read the book too, so if you have anything to add, feel free. I'd love to hear some thoughts!


P.S. I'm out of time for now, but I'll make another post on the balance sheet and cash flow statement later.
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haha I've been reading that also...its such a good book! explains simply and easy to understand...!! I got to keep reading!!


P.S..should I say my real name too? seems like everyone is
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P.S..should I say my real name too? seems like everyone is

Er... Eric you might want to put your first name and the state you live it in your profile, but leave out your last name and the city. You never know who's going to be reading your information on line.
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Hey, hope everyone had a wonderful Christmas! Mine was very relaxing (and fattening!) and I actually received the financial statements book as a gift. Anyway, here are my balance sheet notes from the book that I promised. I'm going to split this into several smaller posts, since this is my second attempt (I accidentally lost my work about halfway through the first time). Enjoy, and please post any thoughts or questions you have!

(Recall that DCA is short for durable competitive advantage)

Cash and Equivalents: Having a lot of cash is good, since it gives a company greater flexibility and liquidity. Ideally, cash should be coming from retained profits, but it can also be raised through the sale of bonds (or more stock). In order to tell where a company's cash is coming from, calculate a debt/cash ratio and look at the trend over time (lower is better). Also compare it to the debt/cash ratios of competitors. The company that relies least on debt will have the lowest ratio.

Net Receivables: In highly competitive industries, companies must often offer customers generous credit terms in order to keep selling products. As a result, they may not collect payment for an order for as much as 120 days, as opposed to the typical 30 day credit period. Businesses with a DCA, however, don't have to use attractive credit terms to lure customers and can collect payment more promptly. Therefore a company with a DCA will usually have a lower Net Receivables/Gross Sales ratio than its competitors.

Current ratio: The ratio of current assets to current liabilities is traditionally considered one of the most important in determining a company's financial health and liquidity. Buffett and Clark, however, argue that this ratio is nearly irrelevant for a company with a DCA. For an average company, it measures how well it can meet its debt obligations for the current year. But a business with a DCA will have such strong earning power that it can easily cover its liabilities as revenue comes in rather than draw from its cash reserves. As a result, it can use its cash for stock buybacks and dividends, which often depresses the current ratio below 1, the typical benchmark. So while the current ratio is important for an average or mediocre company, it is not very indicative of the presence or absence of a DCA since it often makes them look unattractive.
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Property, Plant, & Equipment: Look for low PP&E in a business with a DCA. In industries with strict competition, the authors compare lots of PP&E to "keeping up with the Joneses;" companies must replace or upgrade their equipment before it ceases to be useful in order to match competitors' efficiency levels. This proves very wasteful in the long run. When a DCA exists, the company doesn't have to worry about its equipment becoming obsolete within a few months and doesn't have to replace it until it reaches the end of its useful life. There fore low PP&E costs are a positive thing. I'm not exactly sure how to put PP&E on equal footing for comparison, though, since large companies will naturally have more PP&E than small ones. Any ideas?

Return on Assets (ROA): ROA is an efficiency ratio; it measures the amount of income generated from all of a company's assets. So in most cases, higher is better. A high ratio can be caused by any combination of high income or low assets. If income is the principal cause, great. But if low assets are the cause, it could be a signal that the industry isn't capital-intensive enough to prevent new competitors from easily entering the market. This is dangerous, because it could mean that the company's durable competitive advantage isn't quite so durable. So be wary of an unusually high ROA ratio, and check to see which component (income or assets) is causing it to be so high.

Debt: We discussed this topic in a recent post, which you can read here:
The general idea when looking for a DCA is that if a company must take on debt (not ideal), long-term is better than short-term because it is cheaper and more stable. Look at the 10-year trend in the short/long-term debt ratio for a good idea of how conservative or aggressive a company is in its borrowing.

Debt/Equity ratio: This ratio represents how much of a company's assets are financed with owner's equity and how much is financed with debt. It is calculated by simply dividing Total Liabilities by Owner's Equity. Warren Buffett looks for companies with little or no debt, so the lower the ratio, the better. One adjustment needs to be made, however, in order to make the ratio more representative of the true situation. Under owner's equity, treasury stock (stock the company has bought back) is shown as a negative number. Since it is common for companies with a DCA to buy back stock with excess cash, treasury stock can significantly depress owner's equity and make it look like the company relies on more debt than it actually does. To adjust, add treasury stock back to OE as a positive number. The authors suggest looking for businesses with adjusted D/E ratios of less than 0.8.
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Preferred Stock: Ideally, a company with a DCA will not have any preferred stock on its balance sheet, because although it's technically equity, it acts like debt because the dividend payments are compulsory.

Retained earnings: Consistent growth in retained earnings is an extremely important part of Buffett's durable competitive advantage strategy. With his own company, Berkshire Hathaway, Buffett keeps all or almost all income as retained earnings rather than declaring dividends, and he uses the earnings to purchase other companies with durable competitive advantages. The key here is steady growth in the retained earnings account on the balance sheet.

Return on Equity (ROE): Similar to ROA, ROE is an efficiency ratio that measures the amount of income generated from a company's owner's equity. While higher is generally better, be aware that managers can artificially raise ROE by adding to treasury stock. Recall from the D/E ratio that buying back stock actually decreases owner's equity, since there are less shares available on the market. So to make sure that a high ROE is the result of excellent earnings and not "financial engineering," as the authors call it, add treasury stock back to equity and recompute the ROE ratio.

Look for above-industry-average ROE, which is a sign that a company is making good use of its retained earnings (part of equity) to generate additional profits. This increases the company's underlying value over time. NOTE: Very profitable companies may choose not to retain their earnings and can even show negative ROE while still being in excellent condition. I'm not sure I completely understand this concept, but according to the authors if a business has low or negative ROE but consistently strong earnings, it probably still has a durable competitive advantage.

Miscellaneous Notes from Balance Sheet and Cash Flow Statement
Leverage: Leverage (using large amounts of debt to finance operations) magnifies both gains and losses. A company may seem to have a competitive advantage when in fact its large earnings are a result of massive borrowing. If the means of paying back that debt dries up, as in the case of subprime lenders, it can create a big mess.

Capital Expenditures: As I mentioned under property, plant, and equipment, companies with a DCA don't have to spend as much on capital because they don't need to keep up with the newest technology that competitors are using. You can use a company's 10-year capital expenditure to earnings ratio to get a good long-term perspective on how capital-intensive an industry is. Almost all companies with a DCA should use less than 50% of their net income on capital, and most should use less than 25%.

Buybacks: In many cases, stock buybacks are more beneficial to stockholders than dividends because they increase the underlying value of the business tax-free. When treasury shares increase, the number of shares on the market drops. This raises earnings per share (EPS), which in the long run will increase stock price. So the value of an investment in the company's stock is allowed to grow tax-free until the stock is sold, which makes a big difference over the long run.

Reasons to sell: If you're using the strategy of finding several solid companies with durable competitive advantages, there are only three main reasons why you would want to sell your stock in the company:
1. You need the money for another investment in a better company at a better price (or for retirement, a major purchase, etc.).
2. The company is going to lose its durable competitive advantage, usually as a result of a change in technology or consumer thinking.
3. A bull market inflates the stock price above your estimated long-term target price to an unsustainable level. As a general rule, if the P/E ratio rises above 40, it may be a good idea to sell and wait for the next bear market to buy back into the market.

Hope these helped, and as always, I'd love to get some discussion going about the importance or validity of these numbers as part of the general strategy of finding companies with durable competitive advantages.

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I'm going to split this into several smaller posts, since this is my second attempt (I accidentally lost my work about halfway through the first time).

Jognils, if you are writing in your browser or directly into TMF's response box you can retrieve lost letters, words & posts by holding down the "Ctrl" (control) key while you tap the "Z" key. The more times you tap Z the further back you go.

Whenever I'm writing a post that goes to more than a few paragraphs, especially if it's something I want to save, I type it up in Word which does automatic saves every few minutes whether I tell it to or not. Then it's easy to cut & paste to the Internet.
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Good idea! Thanks for the tip.
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