1. Warren’s two revelations:
1. How do you identify an exceptional company with a durable competitive advantage?
2. How do you value a company with a durable competitive advantage?
2. Benjamin Graham rules:
He was focused on finding companies trading at less than half of what they held in cash. He called it “buying a dollar for 50 cents.”
Never paying more than ten times a company’s earning and selling the stock if it was up 50%.
If it didn’t go up within two years, he would sell it anyway.
3. The downside of Benjamin Graham way:
The first thing was that not all of Graham’s undervalued businesses were revalued upward; some actually went into bankruptcy.
A handful of the companies he and Graham had purchased, then sold under Graham’s 50% rule, continued to prosper year after year;
4. What Warren learned was that these “superstars” all benefited from some kind of competitive advantage that created monopoly-like economics, allowing them either to charge more or to sell more of their products.
Warren also realized that 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 continue to increase year after year.
Warren also noticed that Wall Street – via the value investors or speculators, or a combination of both – would at some point in the future acknowledge the increase in the underlying value of the company and push its stock price upward. It was as if the company’s durable competitive advantage made these business investments a self-fulfilling prophecy.
Because these businesses had such incredible business economics working in their favor, there was zero chance of them ever going into bankruptcy.
To make things even easier, Warren realized that he no longer had to wait for Wall Street to serve up a bargain price. He could pay a fair price for one of these super businesses and still come out ahead, provided he held the investment long enough.
He realized that if he held the investment long-term, and he never sold it, he could effectively defer the capital gains tax out into the far distant future, allowing his investment to compound tax-free year after year as long as he held it.
5. There super companies come in three basice business models:
· They sell either a unique product,
· Or hey sell either a unique service,
· Or they are the low-cost buyer and seller of a product or service that the public consistently needs.
6. Selling a unique product: Coca-Cola, Pepsi, Wrigley, Hershey, Budweiser, Coors, Kraft, The Washington Post, P&G, and Philip Morris.
7. Selling a unique service: Moody’s Corp., H&R Block Inc., American Express Co., The Service-Master Co., and Wells Fargo & Co. A company doesn’t have to spend a lot of money on redesigning its products, nor does it have to spend a fortune building a production plant and warehousing its wares.
8. Being the low-cost buyer and seller of a product or service that the public has an ongoing need for: Wal-Mart, Costco, Nebraska Furniture Mart, Borsheim’s Jewelers, and the Burlington Northern Santa Fe Railway.
In people-specific firms like Solomon Brothers, workers can demand and get a large part of the firm’s profits, which leaves a much smaller pot for the firm’s owners/shareholders. And getting the smaller pot is not how investors get rich.
It is the “durability” of the competitive advantage that creates all the wealth. It is this consistency in the product that creates consistency in the company’s profits. If the company doesn’t have to keep changing its product, it won’t have to spend millions on research and development, nor will it have to spend billions retooling its plant to manufacture next year’s model.
9. The income statement tells us how much money the company earned during a set period of time.
The balance sheet tells us how much money the company has in the bank and how much money it ows. Subtract the money owed from the money in the bank and we get the net worth of the company.
The cash flow statement tracks the cash that flows in and out of the business. The cash flow statement is good for seeing how much money the company is spending on capital improvements. It also tracks bond and stock sales and repurchases.
msn, yahoo, Bloomberg.com
10. An income statement has three basic components: the revenue, the expenses, and the profit/loss.
Not just whether or not the company made money. But what kind of margins it had, whether it needed to spend a lot on research and development to keep its competitive advantage alive, and whether it needed to use a lot of leverage to make money. The source of the earning is always more important than the earnings themselves.
Revenue:
This is the amount of money that came in the door during t he period of time in question.
Cost of Goods Sold / Cost of Revenue:
It is either the cost of purchasing the goods the company is reselling or the cost of the materials and labor used in manufacturing the products it is selling. “Cost of revenue” is usually used in place of “cost of goods sold” if the company is in the business of providing services rather than products. We should always investigate exactly what the company is including in its calculation of its cost of sales. This gives us a good idea of how management is thinking about the business.
Gross Profit:
If we subtract from the company’s total revenue the amount reported as its Cost of Goods Sold, we get the company’s reported Gross Profit.
It doesn’t include such categories as sales and administrative costs, depreciation, and the interest costs of running the business.
Gross Profit Margin
Gross Profit / Revenue = Gross Profit Margin.
49% or better tend to be companies with some sort of durable competitive advantage. Below 40% tend to be companies in highly competitive industries. Any gross profit margin of 20% and below is usually a good indicator of a fiercely competitive industry, where no one company can create a sustainable competitive advantage over the competition.
We should track the annual gross profit margins for the last ten years to ensure that the “consistency” is there.
One of these is high research cost, another is high selling and administrative costs, and a third is high interest costs on debt. Any one of these three costs can destroy the long-term economics of the business. These are called operating expenses.
Operating expenses:
There are all the company’s hard costs associated with R&D of new products, selling and administrative costs of getting the product to market, depreciation and amortization, restructuring and impairment charges, and the catch-all “other” that includes all non-operating, non-recurring expenses.
Operating expenses is subtracted from the gross profit to give us the firm’s operating profit or loss.
Selling, General & Administrative (SGA) Expense
It is where the company reports its costs for direct and indirect selling expenses and all general and administrative expense incurred during the accounting period. These include management salaries, advertising, travel costs, legal fees, commissions, all payroll costs, and the like.
Companies that don’t have a durable competitive advantages suffer from intense competition and show wild variation in SGA as a percentage of gross profit.
30% ratio of SGA to gross profit is considered fantastic. 30% to 80% is also OK.
The economics of companies with low SGA expenses can be destroyed by expensive R&D, high capital expenditures, and/ore lots of debt.
Research & Development:
Companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long-term economics at risk, which means they are not a sure thing.
Depreciation:
All machinery and buildings eventually wear out over time; this wearing out is recognized on the income statement as depreciation. Basically, the amount that something depreciates in a given year is a cost that is allocated against income for that year.
Take buying of the printing press as an example, on the balance sheet, $1 million comes out of cash, and $1 million is added to plant and equipment. Then, for the next ten years, the depreciated cost of $10.000 a year will show up on the income statement as an expense. On the balance sheet each year, $100,000 will be subtracted from the plant and equipment asset account and $100,000 added to the accumulated depreciation liability account. The actual $1 million cash outlay for the printing press will show up on t he cash flow statement under capital expenditures.
EBITDA: Earnings Before Income Tax, Depreciation, and Amortization.
The Wall Street financial types can add that $100,000 cost back into earnings, which means that the cash flow of the business can now support more debt for such fund money-making ventures as leveraged buyouts.
Warren says that by using EBITDA our clever Wall street types are ignoring that eventually the printing press will wear out and the company will have to come up with another $1 million to buy a new one. But now the company is saddled with a ton of debt left over from the leveraged buyout and might not have the ability to finance the $1 million purchase of a new printing press.
Warren believes that depreciation is a very real expense and should always be included in any calculation of earnings. The companies that have a durable competitive advantage tend to have lower depreciation costs as a percentage of gross profit.
Interest Expense:
Interest Expense is the entry for the interest paid out, during the quarter or year, on the debt that company carries on its balance sheet as a liability. This is called a financial cost. Interest is reflective of the total debt that the company is carrying on its books. The more debt the company has, the more interest it has to pay.
Company with a durable competitive advantage often carry little or no interest expense.
The ratio of interest payments to operating income can also be very informative as to the level of economic danger that a company is in.
In any given industry the company with the lowest ration of interest payments to operating income is usually the company most likely to have the competitive advantage.
Gain/Loss Sale Assets:
When a company sells an asset (other than inventory), the profit or loss for the sale is recorded under Gain (or Loss) on Sale of Assets. The profit is the difference between the proceeds from the sale and the carrying amount shown on the company’s books.
Others:
This is where non-operating, unusual, and infrequent income and expense events are netted out. It includes the sale of fixed assets, such as property, plant, and equipment. It also includes license agreements and the sale of patents, if they were categorized as outside the normal course of business.
Since these are nonrecurring events, they should be removed from any calculation of the company’s net earning in determining whether or not the company has a durable competitive advantage.
Income before tax:
It is a company’s income after all expenses have been deducted, but before income tax has been subtracted. It is also the number that Warren uses when he is calculating the return that he is getting when he buys a whole business, or when he buys a partial interest in a company through the open market purchase of its shares.
Warren has always discussed the earnings of a company in pre-tax terms. It is also one of the cornerstones of his revelation that a company with durable competitive advantage is actually a kind of “equity bond,’ with an expanding coupon or interest rate.
Income tax paid:
Today in America, the tax rate is approximately 35%.
Now what is interesting about Income Taxes Paid is that the line item reflects the company’s true pre-tax earnings.
Net Earnings:
First on Warren’s list is whether or not the net earnings are showing a historical upward trend.
But note: Because of share repurchase programs it is possible that a company’s historical net earnings trend may be diffent from its historical per-share earning trend.
Though most financial analysis focuses on a company’s per-share earnings, Warren looks at the business’s net earnings to see what is actually going on.
Good company will report a higher percentage of net earnings to total revenues than their competitors will.
If a company is showing a net earnings history of more than 20% on revenues, it is a good company. If the ration is under 10%, it is bad company, The ratio between 10% and 20% is a gray area. One of the exceptions to this rule is banks and financial companies, where an abnormally high ratio of net earnings to total revenues usually means a slacking-off in the risk management department. It actually indicate an acceptance of greater risk for easier money.
Per-Share Earnings:
The more a company earns per share the higher its stock price is.
A per-share earnings figure for a ten-year period can give us a very clear picture of whether the company is good or not.
Consistent earnings are usually a sign that the company is selling products that don’t need to go through the expensive process of change. The upward trend in earning means that the company’s economics are strong enough to allow it either to make the expenditures to increase market share through advertising or expansion, or to use financial engineering like stock buybacks.
For bad earning company: The booms show up when demand is greater than supply, but when demand is great, the company increases production to meet demand, which increases costs and eventually leads to an excess of supply in the industry. Excess leads to falling prices, which means that the company loses money until the next boom comes along.
“The two biggest weak links in my experience: I’ve seen more people fail because of liquor and leverage – leverage being borrowed money” -- Warren Buffett
Balance sheets, unlike income statements, are only for a set date. We can create a balance sheet for any day of the year, but is will only be for that specific date.
Assets = Liabilites + (Net Worth or Shareholders’ Equity
Current Assets:
It is made up of “cash and cash equivalents,” “short-term investments,” “net receivables,” “inventory,” and “other assets.” They can be or will be converted into cash in a very short period of time (usually within a year).
All other assets:
They will not and cannot be converted into cash in the year ahead. It includes Long-Term Investmetns, Property Plant and Equipment, Goodwill, Intangible Assets, Accumulated Amortization, Other Assets, and Deferred Long-Term Asset Charges.
Current Asset Cycle:
It is also referred to as the “Working assets”.
Cash -> Inventory -> Accounts Receivable -> Cash.
Cash and Cash Equivalents:
It includes Cash, short-term CD at the bank, three-month Treasuries, or other highly liquid assets.
A company has three ways of creating a large stockpile of cash:
1. It can sell new bonds or equity to the public.
2. It can sell an existing business or other assets that the company owns.
3. It has an ongoing business that generates more cash than the business burns. This is the company that Warren wants. We need to look at the past seven years of balance sheets to decide which way the cash is created.
If we see lots of debt, we probably aren’t dealing with an excellent business.
Total Inventory:
With a lot of businesses, there is a risk of inventory becoming obsolete. For good company, the products they sell never change and therefore never become obsolete.
When trying to identify a good company, look for an inventory and net earning that are on a corresponding rise. This indicates that the company is finding profitable ways to increase sales, and that increase in sales has called for an increase in inventory, so the company can fulfill orders on time.
Net Receivable:
When a company sells its products to a purchaser, it does so on the basis of either cash up front or payment due thirty days after the purchaser receives the goods. In some businesses the cash isn’t due for even longer periods. This is called receivable. Since a certain percentage of purchasers that were sold goods will not pay, an estimated amount for bad debts is deducted from the Receivables, which gives us Net Receivables.
If a company is consistently showing a lower percentage of Net Receivables to Gross Sales than its competitors, it is a good company.
Prepaid Expenses:
Businesses sometimes pay for goods and services that they will receive in the near future, although they have not yet taken possession of the goods or received the benefits of the service. Even though the goods or services have not been received, they are paid for, so they are assets of the business. A example is the insurance premiums for the year ahead.
It offers us little information about how good the company is.
Other current assets:
They are non-cash assets that are due within the year but are not as yet in the company’s hands. These include such things as deferred income tax recoveries, which are due within the year, but aren’t cash in hand just yet.
Total Current Assets:
Analysts have traditionally argued that subtracting a company’s current liabilities from its current assets gives them an idea whether the company can meet its short-term debt obligations. They developed the current ratio, which is derived by dividing current assets by current liabilities; A current ratio of over one is considered good, and anything below one bad.
However, the funning thing about a lot of good companies is that quite often their current ration is below the magical one. What is really happening is that their earning power is so strong they can easily cover their current liabilities. Also, as a result of their tremendous earning power, these companies have no problem trapping into the cheap, short-term commercial paper market if they need any additional short-term cash. Because of their great earning power, they can also pay out generous dividends and make stock repurchases, both of which diminish cash reserves and help pull their current rations below one.
Basically, the current ration is almost useless.
Property, Plant and Equipment:
They are assets. They are carried at their original cost, less accumulated depreciation.
A good company doesn’t need to constantly upgrade its plant and equipment before they are worn out in order to stay competitive.
A good company will be able to finance any new plants and equipment internally. A bad company will be force to turn to debt.
As Warren says, producing a consistent product that doesn’t have to change equates to consistent profits.
Goodwill
When Exxon buys XYZ company and pays a price in excess of XYZ’s book value, the excess is recorded under the heading of Goodwill.
Goodwill used to be written off against the earning of the business through a process of amortization. Now, the FASB (Financial Accounting Standards Board) decided that goodwill wouldn’t have to be amortized unless the company that the goodwill was attached to was actually depreciating in value.
Whenever we see an increase in goodwill we can assume that it is because the company is out buying other business. If the goodwill account stays the same year after year, that is because either the company is paying under book value for a business or the company isn’t making any acquisitions.
Net Intangible Assets:
They are assets we can’t physically touch; these include patents, copyrights, trademarks, franchises, brand names, and the like.
If an asset has a finite life – as a patent does – it is amortized over the course of its useful life.
An odd thing is that Coke’s brand name is worth in excess of $100 billion, yet because it is an internally developed brand name, its real value as an intangible asset is not reflected on its balance sheet.
Long-Term Investments:
This is where the value of long-term investments (longer than a year), such as stocks, bonds, and real estate is recorded. This account includes investments in the company’s affiliates and subsidiaries. What is interesting about the long-term investment account is that this asset class is carried on the books at their cost or market price, whichever is lower. This means that a company can have a very valuable asset that is carrying on its books at a valuation considerably below its market price.
Other Long-Term Assets:
An example would be prepaid expenses and tax recoveries that are due to be received in the coming years.
It is useless.
Total Assets:
Return on Total Assets = net earnings / Total assets.
While many analysts argue that the higher the return on assets the better, Warren has discovered that really high return on assets may indicate vulnerability in the durability of the company’s competitive advantage. We also have to consider how large the Total assets are.
Current Liabilities:
They are the debts and obligations that the company owes that are coming due within the fiscal year. It includes Accounts payable, Accrued Expenses, Short-Term Debt, Long-Term Debt Coming Due, and Other Current Liabilities.
Accounts payable:
It is money owed to supplies that have provided goods and services to the company on credit.
Accrued expenses:
They are liabilities that the company has incurred, but has yet to be invoiced for. These expenses include sales tax payable, wages payable, and accrued rent payable.
Other Current Liabliliteis:
It is a slush fund for all short-term debts that didn’t qualify to be included in any of the above categories.
The amount of short- and long-term debt that a company carries can tell a great deal about the long-term economics of a business.
Short-term debt:
It is money that is owed by the corporation and due within the year. This includes commercial paper and short-term bank loans.
Short-term money historically has been cheaper than long-term money. This means that it is possible to make money borrowing short-term and lending it long-term.
We borrow short-term money at 5% and lend it long-term for 7%. When the short-term money is due, we just borrow more money short-term to pay back the short-term debt that is coming due. What if the short-term rate jump to 8%? What is our creditors decide not to loan us any more money short-term? This is what happened to Bear Stearns.
The smartest and safest way to make money in banking is to borrow it long-term and lend it long-term.
When it comes to investing in financial institutions Warren has always shied away from companies that are bigger borrowers of short-term money than of long-term money.
Long-Term Debt Coming Due:
It is long-term debt that is coming due and has to be paid off in the current year.
As a rule, a good company requires little of no long-term debt to maintain their business operation.
Any time we are buying into a company that has a durable competitive advantage but has been going through troubled times due to a one-time solvable event – like a subsidiary in different business bleeding cash, it is best to check the horizon and see how much of the company’s long-term debt is due in the years ahead. Too much debt coming due in a single year can spook investors, which will give us a lower price to buy in at.
Total Current Liabilities:
Total Current Assets / Total Current Liabilities = The current ratio
The higher the current ratio, the more liquid the company is, and the greater its ability to pay current liability when they come due.
While the current ration is of great importance in determining the liquidity of a marginal-to-average business, it is of little use in telling us whether or not a company has a durable competitive advantage.
Long-Term Debt:
It is the debt that matures any time out past a year.
A good company often carrys little or no long-term debt on their balance sheets for the last ten years.
On any given year the good company should have sufficient yearly net earnings to pay off all of its long-term debt within a three- or four-year earning period.
Because these companies are so profitable and carrying little or no debt, they are often the targets of leveraged buyouts. This is where the buyer borrows huge amount of money against the cash flow of the company to finance the purchase. After the leveraged buyout the business is then saddled with large amounts of debt. In cases like this the company’s bonds are often the better bet, in that the company’s earning power will be focused on paying off the debt and not growing the company.
Deferred Income Tax:
It is tax that is due but hasn’t been paid. This figure tell us little about how good the company is.
Minority Interest:
When the company acquires the stock of another, it books the price it paid for the stock as an asset under “long-term investments.” But when it acquires more than 80% of the stock of a company , it can shirt the acquired company’s entire balance sheet onto its balance sheet. The same with the income statement. For example, company A owns 90% of company B, so what the minority interest entry represents is the value of the 10% of company B on A’s balance sheet. It is of little use for finding a good company.
Other Liabilities:
It is a catchall category. It includes such liabilities as judgments against the company, and derivative instruments. It is of little use for finding a good company.
Debt to Shareholder’s Equity Ratio = Total Liabilities / Shareholders’ Equity.
This ratio has historically been used to help us identify whether or not a company is using debt to finance its operations or equity ( which includes retained earnings).
The problem with using the debt to equity ratio as an identifier is that the economics of the good company is so great that they don’t need a large amount of equity/retained earnings on their balance sheets to get the job done; in some cases they don’t need any. They will often spend their built-up equity/retained earning on buying back their stock, which decrease their equity/retained earnings base. That in turn increase their debt to equity ratio.
The simple rule here is that , unless we are looking at a financial institution, any time we see an adjusted debt to shareholders’ ration below .80 ( the lower the better), there is a good chance that it is a good company.
On average, the big American money center backs have $10 in liabilities for every dollar of shareholders’ equity they keep on their books.
Total Shareholders’ Equity /Book Value
It is the net worth of the company. This is the amount of money that the company’s owner/shareholders have initially put in and have left in the business to keep it running.
Common stock represents ownership in the company. Common stock owners are the owners of the company and have the right to elect a board of directors, which, in turn, will hire a CEO to run the company. Common stockholders receive dividends if the board of directors votes to pay them. And if the entire company is sold, it is the common stockholders who get all the loot.
There is a second class of equity, called preferred stock. Preferred shareholders don’t have voting rights, but they do have a right to a fixed or adjustable dividend and must be paid before the common stock owners receive a dividend. Preferred shareholders also have priority over common shareholders in the event that the company falls into bankruptacy.
If the company’s preferred stock or common stock has a par value of $100/share, and it sold it to the public at $120 a share, a $100-a-share will be carried on the books under preferred stock, and $20 a share will be carried under “paid in capital”.
The odd thing about preferred stock is a good company tends not to have any. This is in part because they tend not to have any debt. They make so much money that they are self-financing. And while preferred stock is technically equity, in that the original money received by the company never has to be paid back, it functions like debt in that dividends have to be paid out. But unlike the interest paid on debt, which is deductible from pretax income, the dividends paid on preferred stock are not deductible, which tends to make issuing preferred shares very expensive money.
Retained Earnings:
At the end of the day, a company’s earnings can either be paid out as dividends or used to buy back the company’s share, or they can be kept as “retained earnings” to keep the business growing.
If the earnings are retained and profitably put to use, they can greatly improve the long-term economic picture of the business.
This parameter is of the most important.
Retained Earnings is an accumulated number, which means that each year’s new retained earnings are added to the total of accumulated retained earnings from all prior years.
Treasury Stock/ Treasury Shares:
When a company buys back its own shares, it can either cancel them or it can retain them with the possibility of reissuing them later on, which is called “Treasury Stock”. Shares held as treasury stock have no voting rights, nor do they receive dividends and they are negative value on the balance sheet.
The presence of treasury shares on the balance sheet, and a history of buying back shares, are good indicators that it is a good company.
Return on Shareholders’ Equity:
Shareholders’ equity = total assets – total liabilities
Shareholders’ equity = preferred + common + paid in capital + retained earning – treasury stock.
Shareholders’ equity has three sources. One is the capital that was originally raised selling preferred and common stock to the public. The second is any later sales of preferred and common stock to the public after the company is up and running. The third, and most important to us, is the accumulation of retained earnings.
Net Earnings divided by Shareholders’ Equity equals Return on Shareholders’ Equity. Warren discovered that a good company shows higher-than-average returns on shareholders’equity.
Please note: Some company are so profitable that they don’t need to retain any earnings, so they pay them all out to the shareholders. In this case we will sometimes see a negative number for shareholders’ equity.
If the company shows a long history of strong net earnings, but shows a negative shareholders’ equity, it is probably a good company.
Here is the rule: High returns on shareholders’ equity means “come play.” Low returns on shareholders’ equity mean “stay away.”
The problem with Leverage:
Leverage is the use of debt to increase the earning of the company. The company borrows $100 million at 7% and puts that money to work, where it earns 12%. This means that is earning 5% in excess of its capital costs. That result is that $5 million is brought to the bottom line, which increases earnings and return on equity. The problem with leverage is that it can make the company appear to have some kind of competitive advantage, but it is NOT. Thinks about subprime-lending crisis.
Avoid businesses that use a lot of leverage to help them generate earnings.
With the Accrual Method sales are booked when the goods go out the door, even if the buyer takes years to pay for them. With a Cash Method sales are only booked when the cash comes in. Because almost all businesses extend some kind of credit to their buyers, companies have found it more advantageous to use the Accrual Method, which allows them to book the sales on credit as income under accounts receivable on the income statement.
The cash flow statement breaks down into three sections: cash flow from operating activities; cash flow from investing operations: and cash flow from financing activities.
Capital Expenditures:
They are outlays of cash or the equivalent in assert that are more permanent in nature – held longer than a year – such as property, plant, and equipment. They also include expenditures for such intangibles as patents. Basically they are assets that are expensed over a period of time greater than a year through depreciation or amortization.
Many companies must make huge capital expenditures just to stay in business. If capital expenditures remain high over a number of years, they can start to have deep impact on earnings. Warren has said that this is the reason that he never invested in telephone companies – the tremendous capital outlays in building out communication networks greatly hamper their long-term economics.
As a rule, a good company uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a competitive advantage. We need to look back at a ten-year period to check it.
If a company is historically using 50% or less of its annual net earning for capital expenditures, it is probably a good company. If it is less than 25%, then it is more than likely it is a good company.
Issuance (Retirement) of Stock, Net:
A good company has too much money, it can either pay it out as dividends or use it to buy back shares.
Stock buybacks is Warren’s tax-free way t increase shareholder wealth.
A simple rule is that when we see P/E ratios of 40 or more on these super companies, it just might be time to sell.
