My notes, organized by chapter, may be found below. My intention is to save these notes for my own future reference. All credit belongs to the original authors. Feel free to take a look!
Warren Buffett and the Interpretation of Financial Statements
By: Mary Buffett and David Clark
Part 1: Introduction
Chapter 1
Two great revelations that made Warren the richest man in the world
The purpose of this book is to answer these two revelations:
How do you identify an exceptional company with a durable competitive advantage?
How do you value a company with a durable competitive advantage?
Chapter 2
The kind of business that will make Warren super rich
Benjamin Graham in the 1930s recognized that businesses sold on the stock market that were dropped by investors too quickly would be appropriate to invest in and resell once the initial stock traders recognized their mistake, driving up the value higher than previously and allowing Graham to sell at a higher value. This introduced what is known as Value Investing.
Graham sold companies that rise to 50% Profit on the initial investment or would sell after two years of three was no significant movement on the stock.
Buffett studied under Graham and adjusted this approach. Buffett invested based on "durability" and had no limits to holding on to stocks. Example: Buffett invested $11million in the Washington Post Company in 1973 and has held that until today and has earned a 12,460% Profit at $1.4billion.
Buffett has learned that time will make him rich when he invests in a company that has a durable competitive advantage working in its favor.
Chapter 3
Where Buffett starts his search for the exceptional company
Three basic models: they sell a unique product, they sell a unique service, and/or they are the low-cost buyer and seller of a product or service that the public has an ongoing need for
Unique product: once you own a piece of the customers mind, you never have to change. Think "things just go better with a co*ke"
Unique service: think American express (I want a good credit card) or H&R block (I want to do my taxes)
Low cost buyer and seller: Walmart & Costco. Here, big profit margins are traded at large volumes
It's simple - sell a unique product or service or be the low-cost/low-seller of a product or a service, and you get to cash in, year after year, just as though you broke the bank at Monte Carlo.
Chapter 4
Durability is Buffet's ticket to riches
Coca-cola has been selling the same product for the last 100 years and it will most likely be selling the same product at a high rate for the next 100 years. This creates consistency in the company's financial statements - which is what buffett looks for.
Chapter 5
Financial statement overview: where the gold is hidden
Three kinds:
Income statement: how much money the company earned over a set period of time
Balance sheet: tells how much money the company has in the bank and how much it owes
Cash Flow Statement: tracks the cash that flows in and out of the business
Part 2: The Income Statement
Chapter 7
Where Buffett Starts: The Income Statement
An income Statemet has the basic components: the revenue of the business, then the firm's expenses, which are subtracted from the firm's revenue and tell us whether the company earned a profit or had a loss.
To Buffett, the source of the earnings is always more important to the earnings themselves.
Chapter 8
Revenue: where the money comes in
The first line in the income statement is always total, or gross, revenue. This is the amount of money that came in during the period of time in question
After Buffett has taken a peak at total revenue, he will start to take a hard look at the business expenses
Chapter 9
Cost of Goods Sold (COGS): for Buffett, the lower the better
Just below revenue is is COGS or the Cost of Revenue.
it's 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.
Although the COGS doesn't tell us much about whether the company has a durable competitive advantage, it is essential in determining the Gross profit, which is key in understanding if the company has a long term competitive advantage
Chapter 10
Gross Profit Margin: Key Numbers for Buffet's search for long term gold
Formula: gross profit ÷ total revenue = gross profit margin
What creates a high gross profit margin is the company's durable competitive advantage, which allows it the freedom to price the products and services it sells in excess of its cost of goods sold
As a general rule, companies with a gross profit margin of >40% tend to be companies with some sort of competitive advantage
Chapter 11
Operating Expenses: where buffett keeps a careful eye
A company's operating expenses are all the company's hard costs.
When these entries are added, they make up the total operating expense, which are then subtracted from the gross profit to give us the firm's operating profit or loss
Chapter 12
Selling, General, and Administrative (SGA) expenses
These include salaries, advertising, travel costs, legal fees, commissions, all payroll costs, and the like.
Companies without durable competitive advantage suffer from intense competition and show wild variation in SGA costs as a percentage of gross profit.
In general, look for companies with consistent SGA percentages <30%.
Be sure to verify that they aren't trading lower SGA expenses for disproportionately high research and development,capital expenses, and/or interest expense on their debt load
Chapter 13
Research and Development:
Why Buffett Stays Away From It
If the competitive advantage is the result of some technological advancement, there is always the threat that technology will replace it.
Buffet's rule: companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will put their long-term economics at risk, which means Buffett is not interested.
Chapter 14
Depreciation: A cost buffett can't ignore
Example: imagine a company bought a $1million
Printer with a life span of ten years. Rather than charging the $1mil outright as an expense to the company, the company will "spread out the cost" over the ten year expected lifespan - reporting the charge as $100thousand for each of the ten years.
Buffett has discovered that companies that have a durable competitive advantage tend to have lower Depreciation costs as a percentage of gross profit than those that have to suffer the woes of intense competition. co*ke 7% is better than P&G 57%.
Chapter 15
Interest Expense: what buffett doesn't want
This is the entry for the interest paid out in the debt the company carries on its balance sheet as a liability. This is a financial cost, isolated of production or sales.
Buffett figures that companies with a durable competitive advantage often carry little or no interest expense >15%.
Chapter 16
Gain (or Loss) on Sale of Assets and Other
When a company sells an asset other than inventory, the profit or loss for sale is recorded under Gain (or Loss) on Sale of Assets.
If the company had a building that it paid $1mil for, and after Depreciating it down to $500 thousand, it sold it for $800 thousand, the company would record a gain of $300 thousand.
Other is where unusual, and infrequent income and expenses would be recorded.
Buffett believes these Financials should be removed from any calculation of the company's net earnings to determine a company's durable competitive advantage.
Chapter 17
Income before tax: the number that Warren uses
Buffett always discusses the earnings of a company in pre-tax terms. This enables him to think about a business in terms relative to other business
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Chapter 18
Income Taxes Paid: how buffet knows who is telling the truth
In America, the amount of taxes paid of income is around 35%. When they are paid, they are recorded under the heading Income Taxes Paid.
Take the number a company lists as Pre-tax Income and deduct 35% from it. If the number doesn't equal the Taxes paid, than you need to ask questions.
Companies with durable competitive Advantage don't have to mislead anyone to look good.
Chapter 19
Net earning: what buffett is looking for
After all the expenses and taxes have been deducted from the company's revenue, we get the net earnings.
Buffett looks for whether or not the net earnings are showing an upward trend.
While the total revenue number alone tells us very little about the economics of the business, it's ratio to bet earnings can tell us a lot about the economics of the business compared with other businesses.
co*ke earns 21% on total revenues, while Southwest earns only 7%. > 20% shows durable competitive advantage, while lower than that may mean the company is operating in an intensely competitive market.
Chapter 20
Per Share Earnings: how Buffett tells the winners from the losers
These are the net earnings on a per share basis for the time period in question.
Buffett looks for a per-share earnings picture over a ten-year period that shows consistency and an upward trend.
Part 3
Balance Sheet
Chapter 21
Balance Sheet in General
Balance sheets, unlike income statements, are only for a set date. There is no such thing as a Balance sheet for the year or quarter. There are 2 parts: Assets and liabilities. If we take all the assets and subtract the liabilities, we will get the net worth of the business, which is the same as Shareholder equity.
Chapter 22
Assets
This is where all the goodies are kept: the cash, the plant and equipment, the patents, and all the stuff that riches are made of.
Typically divided into current, and all other assets.
Chapter 23
Current Asset Cycle: how the money is made
Current assets is also referred to as the "working assets" because they are in the cycle of cash going to buy inventory; inventory is then sold to vendors and becomes accounts receivable. Accounts receivable, when collected from vendors then turns back into cash.
Cash -> inventory -> Accounts Receivable -> Cash. This cycle repeats itself over and over again, and it is how a business makes its money.
Chapter 24
Cash and Cash Equivalents: Buffett's pile of loot
A high number for cash tells one of two things - that a company is generating a lot of cash,which is a good thing, or that it has just sold a business or a ton of bonds, which may not be such a good thing. A low amount means that a company has poor or mediocre economics, or that it has just made a larger purchase.
Three ways a business creates 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. Or it has an ongoing business that generates more cash than the business burns.
Scenario #3 is what grabs Buffett's attention.
So here's the rule: If we see a lot of cash and little or no debt going back seven years, chances are good that the business has a durable competitive advantage.
Chapter 25
Inventory: what the company needs to buy and what the company needs to sell
Inventory is the company's products that it has warehoused to sell to its vendors.
Manufacturing companies with a durable competitive advantage have an advantage, the products they sell never change and therfore never become obsolete.
When looking for a manufacturing company with a durable competitive advantage, look for an inventory and net earnings that are on a corresponding rise.
Chapter 26
Net Receivables: money owed to the company
When a company sells its products to a purchaser, it does so on the basis of either cash up front or payments due thirty days (or so) after the purchaser receives the goods. Sales in the state of limbo, where the cash is due, are called Receivables.
Since a percentage of purchasers are anticipated to not pay, an estimated amount of 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 usually has some kind of competitive advantage working in its favor.
Chapter 27
Prepaid Expenses/Other Current Assets
Businesses sometimes pay for goods and services they will receive in the future, although they haven't taken position of them yet.
The current ratio: divide current assets by current liabilities; the higher the ratio, the more liquid the company. Generally, the closer to one, the better. There are some exceptions to the rule, like co*ke (.95) and P&G (.82) because of their great earning power, they can pay out generous dividends, but it's their consistency of their earnings power that displays their competitive advantage.
Chapter 29
Property, Plant, and Equipment: for Buffett, not having them can be a good thing
Companies that don't have a long-term competitive advantage are faced with constant competition, which means they constantly have to update their manufacturing facilities to try and stay competitive, often before such equipment is worn out. This creates a substantial ongoing expense. A durable company doesn't have to do this.
A company with a durable competitive advantage will be able to finance new plants and equipment internally, while others will have to turn to debt to finance its constant need to upgrade their plants to keep up with competition.
Example: chewing gum is not a product that changes much, and Wrigley's brand name ensures its competitive advantage. GM needs to compete with every other car manufacturer on the planet, and it's product needs to be consistently be upgraded - which means their plants need to be constantly upgraded.
Buffett's method is investing in companies that produce a consistent product that doesn't have to change to ensure consistent products.
To get rich, you have to make money. One way to continue to make money is to not have to spend money to keep up with the neighbors.
Chapter 30
Goodwill
When one company buys another company for more than their book value, the excess is recorded on the balance sheet as Goodwill.
When we see an increase in Goodwill over a number of years, we can assume that the company is out buying other businesses. This can be a good thing especially if the company is purchasing other companies with a durable competitive advantage.
Businesses that benefit from some kind of competitive advantage never sell for below their book value. (Wouldn't they just not sell at all?)
Chapter 31
Intangible Assets: measuring the unmeasurable
These are assets we can't physically touch; patents, copyrights, trademarks, franchises, brand names,etc.
In the modern era, companies are not allowed to carry internally developed Intangible assets in their balance sheets - which put an end to watering the balance sheet with fantasy valuations. Purchasing a third party Intangible asset are carried on the balance sheet at their fair value.
Although co*ke and Wrigley have brand name value that is valued in the billions, it is not something that they can display on their balance sheet. Recognizing the "hidden value" in its brand name and the durability that the brand contains in it of itself is a secret to consistent long term investments - especially because it's not something that can be referenced on any of its income statements.
Chapter 32
Long-term investments: one of the secrets to Warren's success
This is where a company's owned stocks, bonds, and real estate is recorded.
This number can tell us a lot of the investment mindset of the top management. Do they invest in businesses with competitive durability or those that are more volatile?
Buffett built Berkeshire Hathaway into the empire it is today by buying a controlling interest, stopped paying the dividend so the cash would accumulate, and then took the company's working capital and went and bought an insurance company. Then he took the assets of the insurance company and went on a 40-year shopping spree for companies with a durable competitive advantage.
Chapter 33
Other long-term investments
Examples are pre-paid expenses and tax recoveries to be received in the coming years.
Not much about competitive advantage can be derived from this section.
Chapter 34
Total Assets and Return on Total Assets
Add current assets to long-term assets, and we get the company's total assets. It's total assets will match its total liabilities, plus shareholder equity. They balance with eachother, which is why it's called a balance sheet.
To measure efficiency, analysts use the return on assets ratio: net earnings / total assets.
Buffett believes that a high return on assets may indicate vulnerability. The lesson is, sometimes more can actually mean less over time.
Chapter 35
Current Liabilities
These are the debts and obligations that the company owes that are due within the fiscal year.
Chapter 36
Accounts payable, accrued expenses, and other current liabilities
AP is money owed to suppliers that have providedgoods and services to the company on credit.
Accrued expenses are liabilities that the company had incurred, but has yet to be invoiced for (sales tax payable, wages payable, accrued rent payable).
In isolation, these sections don't tell much about a company's competitive advantage.
Chapter 37
Short-term debt: how it can kill a financial institution
This is money that is owed by the corporation and due within the year.
Some companies borrow at a low rate and lend it at a higher rate, but this can backfire if the short-term rate that was borrowed jumps higher than the rate it was then lent out at.
Bear Sterns wasn't able to pay back loans because they were backed by long-term loans that couldn't provide the cash when the loan company asked to be paid back in full.
The smartest way to make money in banking is to borrow it long term and lend it long term. That's why banks try to lock people in at 5 and 10 year CDs.
Buffett always shies away from companies that are bigger borrowers of short-term money than of long-term money. Buffett's favorite,Wells Fargo, has 57 cents of short-term debt for every dollar of long-term debt.
Durability of a competitive advantage is a lot like virginity - easier to protect than to get back
Chapter 38
Long-term debt coming due and the trouble it causes
Problems arise when companies lump long-term and short-term debt into one, which creates the illusion that the company has more short-term debt than it really does.
As a rule, companies with more durable competitive advantage require little or no long-term debt ever coming due.
Chapter 39
Total current liabilities and the current ratio
Total current assets / total current liabilities determines the liquidity of the company, the higher the ratio, the greater its ability to pay current liabilities when they come due. This doesn't have much say in whether or not a company is durable, however.
Chapter 40
Long term debt: something that great companies don't have a lot of
Long-term debt means debt that matures anytime out past a year. If the debt comes due within the year, it is short-term debt is placedwith the company's current liabilities.
Highly durable companies have little long-term debt because they can internally fund such enterprises. If the company displays no long term debt for the past five years, this is a good indicator that the company has competitive advantage.
Companies that have enough earning power to pay off their long-term debt in under 4 years are good candidates.
Chapter 41
Deferred income tax, minority interests, and other liabilities
DFI is tax that is due but hasn't been paid (doesn't tell much about durability).
Minority interest is when a company acquires more than 80% of the stock of a company, it can shift the acquired company's balance sheet into its balance sheet - same with the income statement. It would need to charge the 20% the company doesn't own to its liabilities. Still not important to durability, but interesting, anyways.
Other liabilities doesn't matter to durability either lol.
Chapter 42
Total liabilities and the debt to shareholders' equity ratio
Debt to shareholder equity helps us to identify whether or not a company is using debt to finance its operations or equity (which includes retained earnings). The more durable company should show a higher level of shareholder equity and a lower level of liabilities.
The equation: debt to shareholders equity ratio = total liabilities ÷ shareholders equity.
It's not a hard and fast assessor because some companies have such good economics that it doesn't need to maintain any shareholder equity.
If a company has a .68 ratio, this means that for every dollar of shareholder equity the company has, it also has 68 cents in debt. If a company has a ratio of 38, this means that for every dollar of shareholder equity the company has, it has 38 dollars in debt.
Banks are an exception because their business model is loaning out money with expected interest in repayment. Banks, on average, have $10 in liabilities for every $1 of shareholder equity.
The simple rule is that, unless we are looking at a financial institution, anytime we see an adjusted debt to shareholder debt to equity ratio below .80, there is a good chance the company has a competitive advantage.
Chapter 43
Shareholder's equity/ book value
If you take a company's total assets and subtract is total liabilities, you get the net worth of the company, which is also known as the shareholders equity or book value of the business. This is the amount of money that the shareholders have put in and have left the business to keep running.
Shareholders equity is accounted for under the heading Capital Stock.
Chapter 44
Preferred and Common Stock: Additional Paid In Capital
A company can raise new Capital by selling bonds or stock (equity) to the public. Bonds need to be paid back, stocks don't need to be paid back.
Common stock represents ownership of the company. Stock owners have the right to elect a board of directors, which, in turn, hire the CEO. Common stock owners receive dividends if the board elects to pay them. When the company is sold, the common stock owners get the loot.
Preferred stock owners get priority to dividends and funds from company buy-outs.
One of the markers we look for in our search for a company with a durable competitive advantage is the absence of preferred stock in its Capital structure.
Chapter 45
Retained Earnings: Buffett's secret to getting super rich
At the end of the day, a company's net earnings can either be paid out as dividends, used to buy back it's shares, or they can be retained 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.
Retained earnings is an accumulated number, which means that each new year's new Retained earnings are added to the total of all prior years. This is the most important number used in determining if a company is durable with a competitive advantage.
Simply put, the rate of growth of a company's Retained earnings is a good indicator whether or not it is benefited from having a durable competitive advantage. Good businesses examples: co*ke 8%, Wrigley 11%, wells Fargo 14%, Berkeshire Hathaway 23%.
One way Buffett grew BH was by refusing to pay dividends. Instead, he has used the Retained earnings money to keep buying companies that have a durable competitive advantage, and adding all that money back into the Retained earnings pool, and eventually invested in even more money-making operations.
Chapter 46
Treasury Stock: buffett likes to see this on the balance sheet
When a company buys back it's own stock, it can cancel them or it can keep them with the possibility of issuing them later on. The later is referred to as Treasury stock.
Companies with a durable competitive advantage tend to have lots of free cash they can spend on buying back their shares - hence,the presence of Treasury shares on the balance sheet.
Put simply: the presence of Treasury shares on a balance sheet and a history of buying back shares are good indicators that the company has a durable competitive advantage.
Chapter 47 & 48
Return on Shareholers Equity Part 1 & 2
Shareholder equity = total assets - total liabilities
Has three sources: raised capital, sales of preferred and common stock, the accumulation of Retained earnings (the most important to us).
If management is good at allocating it's invested money, investors will invest more - if not, investors will sell.
Return on shareholder equity = net earnings / shareholders equity. The higher the better.
Examples: co*ke 30%, Hersheys 33%, Pepsi 34%.
The less the % of the industry leader, the more the competitiveness of the industry.
High returns on equity mean the company is making good use of earnings that is Retained.
Rule: high returns on shareholders equity means "come play" otherwise, "stay
Away".
Chapter 49
The problem with leverage and the tricks it can play on you
Leverage is the use of debt to increase the earnings of the company.
Bank example: they borrow $100 billion at 6% interest, and they lend it out at 7% interest. This means they are earning 1% in the $100 billion, which equates to $1 billion, which creates the appearance of competitive advantage.
Buffett avoids businesses that use a lot of leverage to help them generate earnings.
Part 4
The Cash Flow Statement
Chapter 50
The Cash Flow Statement: where buffett goes to find the cash
The cash flow statement will tell us if the company is bringing in more cash than it is spending (positive cash flow) or if it is spending more cash than it is bringing in (negative cash flow). They are like income statements in that they cover a set period of time (every three months, and yearly).
Three sections: operating activities, investing operations, and financing activities.
Chapter 51
Capital Expenditures: not having them is one of the secrets to getting rich
These are assets that expensed over a period of time greater than a year through depreciation and amortization, listed under investment operations.
As a rule, a company with a durable competitive advantage uses a smaller portion of its earnings for capital Expenditures for continuing operations than do those without a competitive advantage.
Both co*ke and Moody have enough excess income to have stock buyback programs that reduce the number of shares outstanding, while at the same time reducing debt or keeping it low.
When we look at capital Expenditures in relation to net earnings we add up a company's total capital Expenditures for a ten-year period and compare the figure with the company's total net earnings for the same-period.
Buffett leans toward companies that use >50% of its annual net earnings for capital Expenditures.
Chapter 52
Stock buybacks: Buffett's tax-free way to increase shareholder wealth
Buffett loves to use his company's excess money to buy back the company's shares. This reduces the number of outstanding shares, such increases the remaining shareholders interest in the company, and increases the per-share earnings of the company, which eventually makes the stock price go up. The best part is that there is an increase in shareholders wealth that they don't have to pay taxes on until they sell their stock.
To find out if a company is buying back it's shares, go to the cash flow statement and look under investing activities - there, you will find a heading titled "issuance of stock, net".
In other words, one of the indicators of the presence of a durable competitive advantage is a "history" of the company repurchasing or retiring its shares.
Part 5
Valuing the company with a durable competitive Advantage
Chapter 53
Buffett's revolutionary idea of the equity bond and how it has made him super rich
To Buffett, the shares of a company with a durable competitive advantage are the equivalent to equity/bonds, and the company's pretax earnings are the equivalent of a normal bonds coupon or interest payment.
Chapter 54
The ever-increasing yield created by the durable competitive advantage
This chapter provides examples of competitively advantaged companies and their yields on their equity bonds/shares have increased over time.
With all of these companies, their durable competitive advantage caused their earnings to increase year after year, which, in-turn, increases the underlying value of the business.
Chapter 55
More ways to value a company with a durable competitive advantage
This chapter reemphasizes how Buffett has approximately $64billion in capital gains and has yet to pay taxes on it because he continues to hold his stocks.
Chapter 56
How buffett determines the right time to buy a fantastic business
Since Buffett is looking at a company with a durable competitive advantage as being a kind of equity bond, the higher the price he pays, the lower his initial rate of return and the lower the rate of return on the company's earnings in ten years. The lower the price you pay for a company with a durable competitive advantage, the better you are going to do over the long term, and Buffett is all about the long term.
So when do you buy? Bear markets. Buffett has said that a wonderful buying opportunity can present itself when a great business confronts a one-time solvable problem.
When do you stay away? At the height of bull markets. Even a company with durable competitive Advantage can't unmoor itself from producing mediocre results for investors if they pay too steep a price for admission.
Chapter 57
How Buffett determines its time to sell
In Buffet's world, you would never sell a business maintaining a competitive advantage. Simply because the longer you hold on to them, the better you do. Also, the moment you do seek them, you invite the tax person to the party.
All that being said, the reasons provided:
When you need money to make an investment in an even better company at a better price.
When the company looks like it is going to lose its competitive advantage.
During bull markets when the stock market sends the prices through the ceiling. If we do sell at that time, don't buy a separately conflated stock, but wait for the next bear market, instead.
