WB Interpretation FS Flashcards
3 types of businesses Warren looks for?
1 sell unique product
2 sell unique service
3 low cost buyer and seller of product/service
How do you notice the durability of a company’s competitive advantage 5 things?
1 consistent high gross margins 2 consistently carry little or no debt 3 consistently not spend high sums on R&D 4 consistent earnings 5 consistent growth in earnings
We should always. Investigate what the company is including in its…(against revenues)
What idea does this give us?
Cost of goods sold/cost of sales calculation
How management is thinking about business
Gross profit margin equation?
Gross profit margin = gross profit/total revenues
Gross profit margin significance?
Companies that have excellent Longterm economics
Have consistently higher gross margins than those
That don’t
Range of good gross profit margins for warren’s key companies?
Bad gross profit margins?
What % equals a fiercely competitive industry?
Good: over 40%, excellent 51%-73%
Bad: under 40%
Fiercely competitive industry: under 20%
How many years should be used to track the consistency of profit margins having a durable competitive advantage?
10 years
What are 4 ways a company with a high gross margin can be stripped of its durable competitive advantage?
1 high research costs
2 high selling and administrative costs
3 high interest costs on debt
4 high capital expenditures
What is important to see with selling, general and administrative expenses in a company with a durable competitive advantage?
Examples?
Consistent percentage of SGA Expenses to gross profit
Year after year
Coca cola SGA expenses are 59% of its gross profit
Moody’s 25%, Proctor & Gamble 61%
What percentage is considered fantastic for selling, general and administrative expenses for a company?
Below 30%,
but can still be durably competitive between 30% and 80%
R&D costs and durable competitive advantage?
Companies that have to spend large amounts on R&D
Have flawed Longterm economics
What does Warren think of EBITDA? What should be included in calculating earnings?
It’s not a good calculation because it ignores the very
Real cost of depreciation
Depreciation should be included in calculating earnings
How depreciation relates to durable competitive advantage?
Durably competitive Companies have lower depreciation
Costs as % of gross profit
Compared to companies that suffer from high competition
Examples of good ratios of depreciation expenses to gross profit?
Good: consistently 6 to 8%
Bad: GM runs 22% to 57% depreciation expenses
Companies with a durable competitive advantage carry…
Little or no interest expense
Acceptable examples of interest expense to operating income ratios?
Proctor & Gamble 8% of operating income to interest expenses
Wriggled pays 7% operating income to interest expenses
Southwest pays 9% operating income to interest expenses
Acceptable ratio interest expense to operating income ratios?
Acceptable examples of interest expense to operating income ratio for the banking industry?
15% general
30% interest expense to operating income banking industry
Nonrecurring events when calculating earnings?
Non recurring events should not be included in the
earnings calculation
Significance of income before taxes?
Number warren uses when calculating the return he
Is getting when he buys the whole business or stock
Income taxes telling the truth? What to know?
Check the taxes filed with the SEC see if telling truth
See if matches income statement
As of 2014, the corporate tax rate for over $18,333,333
Is 35%
Look at corporate tax table
Durable competitive advantage and net earnings?
Examples?
Over the long term companies will report a higher
percentage of net earnings to total revenues than
Their competitors
Coca cola earns 21% on total revenues
Moody’s earns 31% on total revenues
Durable competitive advantage: net earnings percentage, what is considered excellent? What’s considered gray area?
What industry should not be evaluated based on this ratio?
Company showing net earnings history of more than 20%
On total revenues
Gray area 10% to 20%
Banks and financial companies should not be evaluated
based on this ratio
Durable competitive advantage: what period should be used to analyze earnings per share? What should you look for?
10 year period
Consistently upward trend
What does an upward trend in earnings show?
Types of expenditures?
Company’s economics are strong enough to allow it
To make expenditures to increase market share
Through advertising or expansion or financial engineering
Like stock buy backs
When a company has a high amount of cash it tells warren one of two things?
1 company has competitive advantage generating a ton
Of cash which is good
2 company just sold a business or a ton of bonds
Which may or may not be good
How to test where the company’s cash is coming from?
What is a good indicator the company has a durable competitive advantage?
Look through 7 years worth of balance sheets
Good: little or no debt, no sale of shares or assets
While seeing a history of consistent earnings
What advantage does manufacturing company have?
Products they sell never change and never become
Obsolete
When trying to identify a manufacturing company with a durable competitive advantage look for…
What does this show?
Inventory and net earnings that are on a corresponding rise
Means company is finding profitable way to increase sales
Which calls for an increase in inventory
Inventories, what’s considered bad with manufacturing companies?
When inventories ramp up for a few years and just as
Quickly ramp down
Shows companies caught in highly competitive industries
prone to booms and busts
What’s bad to see when testing where a company’s cash is coming from?
Issuing debt and stock
Competitive advantage: net recievables?
If company consistently shows a lower percentage of
Net receivables to gross sales than its competitors
It has competitive advantage working in its favor
Durable competitive advantage: current ratio?
Durably competitive companies can have a current ratio
Below 1 as long as they have consistent earning power
Durable competitive advantage: property, plant, equipment
Company doesn’t have to constantly upgrade its equipment
To stay competitive, only updates when it wears out
Can finance new plants and equipment internally
(not use stock or debt financing)
Businesses that benefit from a durable competitive advantage almost never…
Sell for below their book value
Looking at a companies Longterm investments can show?
Insight in How Management invests. Do they invest
in companies With a durable competitive advantage?
Or mediocre companies?
Return on assets ratio
Return on assets = net earnings/total assets
In 2008 Moody’s has $1.7 billion in assets and shows a return on assets of 43%, while Coca Cola has $43 billion in assets and shows a return on assets of 12%, what does this mean?
Moody’s has underlying economics far superior to
Coca Cola,
the durability of Moody’s competitive advantage is
Far weaker than coca cola because a competitor
Could rake in $1.7 billion to take on Moody’s
Raising $43 billion to take on Coke is an impossible
Task
The smartest and safest way to make money in the banking industry? It’s dangerous to?
Examples?
is to borrow Longterm and lend long term
Dangerous to borrow short term and lend Longterm
Because interest rates might jump
Wells Fargo $.57 short term debt for ever $1 of long term
Debt
BAC has $2.09 short term Debt for every $1 of long term
Debt
When a company has long term debt it is important to…
When can it spook investors?
Check when it will come due
It can be confusing and spook investors when it gets
Lumped with short term debt on a balance sheet
The current ratio is of great importance in determining…
The liquidity of a marginal to average business, but
Of little use of telling us about a company with a
Durable competitive advantage
Durable competitive advantage: long term debt?
Why?
Companies have a durable competitive advantage when
they carry little or no long term debt
because these companies are so profitable they are Self
financing when they are expanding the business/making acquisitions
Period to look for long term debt and why?
If there has been 10 years of operations with little or no
Longterm debt on the balance sheet the company
Has some kind of durable competitive advantage
With long term debt, Warren’s historic purchases indicate
On any given year the company should…
Have sufficient yearly earnings to pay off all long term
Debt within 3 or 4 year earning periods
Leveraged buyouts of excellent companies result in…
Why?
Creating a lot of debt or the company, so bonds are usually
The better investment
because the company will focus on paying off the debt over
Growth
Minority interest entry?
When a company acquires more than 80% of another
Company it can shift that company’s entire balance
Sheet onto its own balance sheet
Minority interest represents the remaining percentage
The company doesn’t own
Identifying a durable competitive advantage: Adjusted Debt to Shareholder’s Equity Ratio? What’s a good value for a durable competitive advantage?
Examples of good ratios
Debt to Shareholder’s Equity Ratio =
(Total Liabilities)
/(Shareholder’s Equity + treasury stock from share Buybacks)
Below .80 is good
Ex Moody’s = .63, Cokes =.51, Proctor & Gamble = .71
Bad: Goodyear = 4.35, Ford = 38
Adjusted Debt to Shareholder’s Equity Ratio: Banks?
Have much higher debt to Shareholder’s Equity Ratios
Usually over 10
Warren Buffett really likes M & T Bank which has
A ratio of 7.7
Durable competitive advantage: Preferred stock,
How does it relate to pretax income?
Companies that have a durable competitive advantage
Tend to not have any preferred stock
Dividends paid on preferred stock are not deductible
From pretax income making preferred shares expensive
Money
Durable competitive advantage retained earnings?
Good measure: the 5 year rate of growth of retained
Earnings indicates if company has competitive advantage
Ex: coke 7.9% RE growth, Wrigley 10.9%, Burlington Northern 15.6%, Berkshire Hathaway 23%
Retained earnings, what changes them without internal growth?
Acquisitions
Durable competitive advantage: treasury shares
The presence of treasury shares on the balance sheet and
A history of share buy backs
Signals the company has a durable competitive advantage
Determining the company’s return on shareholders equity without the effects of financial engineering, equation?
Return on Shareholder’s equity adjusted for financial engineering
= (net earnings)/(shareholder’s equity + treasury stock)
Return on Shareholder’s equity equation?
Significance?
Examples?
Return on Shareholder’s equity =
Net earnings/Shareholder’s equity
Companies that benefit from a durable competitive
advantage Show higher than avg. returns on shareholder’s
equity
Ex. Coke 30%, Wrigley 24%, Hershey 33%, Pepsi 24%
Some companies are so profitable that they do not need to…
What should you not confuse these companies with?
Retain earnings, so they pay them all to Shareholder’s, these
Companies will have a strong earnings history
Don’t confuse these companies with mediocre companies that have no retained earnings (negative earnings history)
Durable competitive advantage: leverage?
Warren has learned to avoid businesses that use lots of
Leverage to help generate earnings
Durable competitive advantage: capital expenditures listed on the cashflow statement? Examples of excellent companies?
Historically if a company is using less than 50% of its
Earnings on capital expenditures that is good
Excellent if using less than 25%
Ex. Coke 19%, Moody’s 5%, American Express 23%
Durable competitive advantage: cash flow statement- cash from investment activities “issuance (retirement) of stock, net”. AKA Share buy backs (retirements)?
Tax free way of increasing shareholder value
Good if company has a history of buying back shares
How warren sees shares as an equity bond? What is the “bond” and what is the “coupon/interest”?
“bond” = company’s shares/equity
“coupon/interest payment” = company’s pretax earnings
not the dividends the company pays out but the pretax earnings
Equity bond coke: stock price $6.50, pretax earnings $.70/sh. , after tax earnings $.46/sh, annual rate of earnings growth 15%.
What is the pretax interest rate paid for the equity bond and what will eventually happen?
The pretax interest rate = .7/6.5 = 10.77%
It will eventually become 15%
In 2008, Cokes pretax earnings = $3.96 and long term corporate interest rates are approximately 6.5%. Whats the valuation of coke?
3.96/.065 = $60.92
That year the market valued coke between $45 and $64
What is a big reason the stock market eventually tracks the increase in these companies’ underlying values?
Their earnings are consistent
When interest rates drop, a company’s earnings are…
When interest rate rise?
Worth more, because they will support more debt
Making the company’s shares worth more
Rise: earnings are worth less, because they will support
Less debt, making the company’s stock worth less
Over the long term what determines the economic reality of what long term investments are worth?
Long-term interest rates
When is the right time to buy? The wrong time?
Right: bear markets, when the business confronts a one time solvable problem
Wrong: the height of bull markets
When is the right time to sell a business with a durable competitive advantage?
Try not to, avoid taxes, only if you see a better investment
Alternative, or when the company loses its durable
Competitive advantage
Or if the p/e exceeds 40
What long term corporate bond yield should be used to valuate stocks?
Moody’s seasoned baa corporate bond yield
