How Warren Buffett Selects Companies
Learning how Warren Buffett values potential investments based on the book “Warren Buffett and the Interpretation of Financial Statements”.
In this chapter, we’ll take a look at:
The Book “Warren Buffett and the Interpretation of Financial Statements” is a quick and easy to understand introduction to reading financial statements. It was written by Mary Buffett and David Clark and got released in 2008.
According to the authors Warren Buffets only considers investments if a company has a durable competitive advantage which ensures long-term growth of the investment. The book focuses on how to identify those companies with a competitive advantage and how to value them.
This article discusses the biggest learnings from the book and how to apply them in practice.
The Origins Of Warren Buffetts Investing Philosophy
Warren Buffett originally was a big follower of Benjamin Graham and his value investing approach.
Graham focused on companies in economic trouble and was mainly focused on whether those companies had sufficient earnings power to get out of those troubles. He discovered that traders were only interested in short-term gains and were driving prices up or down causing a mismatch with a stocks valuation. As a result he could invest in those beaten down companies as the market would sooner or later acknowledge the true value of the stock.
Contrary Buffett discovered that companies with long-term competitive advantages have wealth-creating economics. This means he didn't need to wait for the company to be under priced as even at fair value he could still get rich. As long as the competitive advantage could be maintained for a long period of time the underlying value of the business would continuously increase.
Because of their competitive advantage those businesses would have zero chance of bankruptcy which made them great long-term investments. Even better those investments would get less risky the more traders would drive down their prices.
The Competitive Advantage of a Business
According to Buffett, companies with a competitive advantage either sell a unique product, a unique service or they are the low-cost buyer or seller of a product that is consistently bought. Those companies have their competitive advantage in their favour as the either have low costs associated with their business or make huge profits due to high volume.
In addition the durability of a business model is key to creating wealth for investors. The consistency of a product or service with a competitive advantage creates consistency in the company's profits. A consistent product doesn't require investments into research and development or expensive retooling and new factories. As a result the money keeps on growing and fewer debt is required to keep the company running.
There are four main questions which point to a competitive advantage for a business:
- Does it consistently have high gross margins?
- Does it consistently carry little or no debt?
- Does it consistently have low research and development costs?
- Does it show consistent earnings?
A High Gross Profit Margin Is a Good Sign
To Warren Buffett the gross profit margin is a key indicator to identify a business with a competitive advantage.
To calculate the gross profit margin an investor first needs to calculate the gross profit. To do this the investor takes the total revenues from the income statement and subtracts the costs of goods sold from it. The gross profit does not include administrative costs, depreciation and the interest expense of the business.
The costs of goods sold are either the costs for purchasing products that are being sold or the costs for materials and labor used in manufacturing a product. As every business defines those differently investors should take a closer look what costs are included in the calculation of its costs of goods sold. Generally the lower the costs of goods sold the better for the bottom line of the business.
While the gross profit itself is not very interesting the gross profit margin is. It is being calculated by dividing the total gross profit by the total revenue. Warren Buffett found that companies with an excellent long-term advantage tend to have higher gross profit margins. This is the case because companies without a competitive advantage have to compete by lowering prices while companies with a competitive advantage generally face less competition.
According to Buffett companies with a gross profit margin of 40% or better tend to have a competitive advantage while companies below 20% usually take part in fierce competition. To be safe the gross profit margin should be tracked for the last 10 years to ensure that it is consistent.
Operating Expenses Should Be as Low as Possible
Operating expenses are the company's costs for research and development, selling, administrative costs, depreciation and amortization, restructuring and impairment charges and any other expenses. Companies without a competitive advantage usually have a big variation in selling and administrative costs as a percentage of their gross profit. In general the lower a company's operating expenses are the better for its shareholders. Anything below 30% of a company's gross profit is fantastic.
If the competitive advantage of a company relies on a patent or technological advancement the advantage will disappear once the patent expires or new technology is available. As a result those companies have to spend a lot on research and development, as well as selling and administrative costs causing lower profits for shareholders.
While the interest expense is a financial cost, not an operating cost, it still is important to look at. Companies in fiercely competitive industries tend to have higher interest expenses as more debt is required to stay competitive. In general companies with a competitive advantage should pay less than 15% of their operating income in interest.
The ratio between interest payments and operating income can also be very revealing whether a company is in economic danger. Sudden jumps in the interest expense ratio should be taken as a warning sign that a company might be in serious trouble.
Net Earnings Reveal a Competitive Advantage
The net earnings of a company are calculated by subtracting expenses and taxes from the total revenue. One caveat is that nonrecurring events like the sale of an assets and other infrequent income or expenses should be removed from any calculation of the company's net earnings as it otherwise might skew the results.
Investors should always check whether net earnings show a historical upwards trend to determine if there is consistency and a possible competitive advantage. There should be caution though as share repurchase programs might skew the results. With those programs the number of shares gets reduced and as a result the earnings per share increase.
According to Buffett companies with a competitive advantage tend to report a higher ratio of net earnings to total revenue. If a company is showing a net earnings history of more than 20% of total revenue it most likely has the competitive advantage that Warren Buffett seeks.
Warren Buffett dislikes the idea of EBITDA as it removes depreciation and amortization from the earnings making them seem to be bigger than they actually are in the short-term. Contrary he considers depreciation a real expense as worn down equipment has to be replaced at some point in the future and as a result this will lower future profits. He rather uses income before tax to determine the return he can expect from an investment. Income before tax is calculated by subtracting all expenses, except for taxes, from the revenue. Using income before tax enables easier comparisons between companies as they might have different tax rates.
Checking the Liquidity of a Business
Current assets are assets that can be converted into cash in less than one year. They include cash and cash equivalents, short-term investments, net receivables, inventory and other assets. The balance sheet usually lists them in the order of liquidity, meaning how soon they can be converted to cash.
A high number of cash or cash equivalents points to a competitive advantage which generates lots of cash. It however can also point to a recent sale of bonds or a sale of a part of a company's business. A business with large amounts of cash will have little problems maneuvering through troubled times.
Similar to current assets current liabilities are liabilities which are due within the fiscal year. Contrary long-term debt is due after the current fiscal year.
The current ratio points to how liquid a company is. It is calculated by dividing current assets by current liabilities. Any current ratio below 1 is considered bad and a sign of a business which has a hard time to meet short-term obligations.
However there is one exception for companies with a competitive advantage. Their tremendous earnings power allows them to repurchase shares or pay out dividends to their shareholders. This can have the effect that the current ratio is falling below 1 despite their ability to pay their short-term obligations.
The Lower Liabilities Are the Better
The total liabilities is the sum of all liabilities of the company. It is an important number as it is used to calculate the debt to shareholders equity ratio. The ratio is calculated by dividing total liabilities by shareholders equity. It indicates whether a company uses debt or shareholders equity to finance its operations. A company with a competitive advantage will use shareholders equity rather than debt.
As a rule companies with a durable advantage require little to no debt to run their business. This is because those companies tend to self-finance business expansions or acquisitions. There should be consistently little or no debt on the balance sheet over at least 10 years for a company with a competitive advantage.
One caveat with the debt to shareholders equity ratio is that repurchased shares might show up as debt in the form of treasury stock on the balance sheet. Therefore the debt should be adjusted to exclude any treasure stock. Treasure stock is a good sign of a competitive advantage as it means the company is doing well enough to buy back its own shares.
In general companies with a competitive advantage tend to have a debt to shareholders equity ratio below 0.80. One exception are banks which usually have much more liabilities as a result of their business model. They tend to have a much higher ratio as a result.
By subtracting the total liabilities from the total assets of a business an investor calculates the shareholder equity, which is also know as book value. This is the amount of money owned or owed by the shareholders of the company.
Return on Assets Reveal the Efficiency of a Company
The return on assets ratio determines the efficiency of a company. It is being calculated by dividing net earnings by total assets. The total assets are current assets plus long-term assets.
Long-term assets will take more than 1 year to be converted into cash. They include long-term investments, property and equipment, goodwill, intangible assets, accumulated amortization and other assets.
While a bigger return on assets is generally a good sign of a business with a competitive advantage it can also indicate a vulnerability for example due to a lower entry barrier to compete.
Retained Earnings Are One of the Most Important Factors
Retained earnings are earnings which haven't been paid out by the company in the form of dividends. Its is an accumulated number which means that any earnings which haven't been paid out get added to it. Likewise losses get subtracted from retained earnings.
The retained earnings are one of the most important factors to determine if a company has a competitive advantage. This advantage can be discovered by looking at the average growth rate of retained earnings over a long time period. The higher the growth rate the more likely the company has a competitive advantage. Investors should be careful when looking at the growth rate as acquisitions can also lead to a growth in retained earnings.
Net earnings divided by the shareholders equity equals the return on shareholders equity. According to Warren Buffett high returns on shareholder equity tend to be a sign of companies with a competitive advantage as it means that the company is making good use of retained earnings.
When to Invest in a Company
The big difference between Buffetts and Grahams value investing approach is that Graham calculates an intrinsic value and buys a company when its share price falls below this value.
Buffett on the other hand sees companies with a competitive advantage more like an equity bond where he is being offered a relatively risk free rate of return for a given business which is continuously increasing over time as the business becomes more valuable. This happens as the market tends to price a business fairly over the long-term based on its competitive advantage.
However Buffett still looks to pay as little as possible for his investment as a high initial investment price directly affects his return on investment. That's why he prefers to buy business in bear markets when their prices are at their lowest rather than in bull markets where prices businesses trade at high price to earnings ratios.
Next Chapter
Continue with the next lesson of our beginner-friendly guide “Popular Investors”.