Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage

by Mary Buffett

Warren has figured out that these super companies come in three basic business models: They sell either a unique product or a unique service, or they are the low-cost buyer and seller of a product or service that the public consistently needs.

To Warren, the source of the earnings is always more important than the earnings themselves.

Total Revenue comes the Cost of Goods Sold, also known as the Cost of Revenue.

“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.

Gross Profit ÷ Total Revenues = Gross Profit Margin

What creates a high gross profit margin is the company’s durable competitive advantage,

As a very general rule (and there are exceptions): Companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage. Companies with gross profit margins below 40% tend to be companies in highly competitive industries, where competition is hurting overall profit margins (there are exceptions here, too). 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.

to be on the safe side we should track the annual gross profit margins for the last ten years to ensure that the “consistency” is there.

Now there are a number of ways that a company with a high gross profit margin can go astray and be stripped of its long-term competitive advantage. One of these is high research costs, another is high selling and administrative costs, and a third is high interest costs on debt.

management salaries, advertising, travel costs, legal fees, commissions, all payroll costs, and the like.

“Consistently”

lower the company’s SGA expenses, the better.

under 30% is considered fantastic.

However, there are a number of companies with a durable competitive advantage that have SGA expen...

But if we see a company that is repetitively showing SGA expenses close to, or in excess of, 100%, we are probably dealing with a company in a highly competitive industry where no o...

Intel is a perfect example of a company that has a low ratio of SGA expenses to gross profit, but that because of high research and development costs has seen its long-term economics reduced to just average.

Warren has learned to steer clear of companies cursed with consistently high SGA expenses.

He also knows that the economics of companies with low SGA expenses can be destroyed by expensive research and development costs, high capital expenditures, and/or lots of debt.

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.

What Warren has discovered is that companies that have a durable competitive advantage tend to have lower depreciation costs as a percentage of gross profit than companies that have to suffer the woes of intense competition.

As an example, Coca-Cola’s depreciation expense consistently runs about 6% of its gross profits, and Wrigley’s, another durable competitive advantage holder, also runs around 7%.

Interest Expense is the entry for the interest paid out, during the quarter or year, on the debt the company carries on its balance sheet as a liability.

This is called a financial cost, not an operating cost, and it is isolated out on its own, because it is not tied to any production or sales process.

debt the company has, the more interest it has to pay.

where large capital expenditures are required for it to stay competitive, or a company with excellent business economics that acquired the debt when the company was bought in a leveraged buyout.

Long-term competitive advantage holder Procter & Gamble has to pay a mere 8% of its operating income out in interest costs; the Wrigley Co. has to pay an average 7%;

As a rule, Warren’s favorite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income.

be aware that the percentage of interest payments to operating income varies greatly from industry to industry. As an example: Wells Fargo, a bank in which Warren owns a 14% stake, pays out approximately 30% of its operating income in

A careful eye would have picked up the fact that in 2006 Bear Stearns reported that it was paying out 70% of its operating income in interest payments, but that by the quarter that ended in November 2007, its percentage of interest payments to operating income had jumped to 230%.

The rule here is real simple: In any given industry the company with the lowest ratio of interest payments to operating income is usually the company most likely to have the competitive advantage.

The profit is the difference between the proceeds from the sale and the carrying amount shown on the company’s books. If the company had a building that it paid $1 million for, and after depreciating it down to $500,000, sold it for $800,000, the company would record a gain of $300,000 on the sale of the asset. Likewise, if the building sold for $400,000, the company would record a loss of $100,000.

The same thing applies to the entry “Other.” This is where non-operating, unusual, and infrequent income and expense events are netted out and entered onto the income statement. Such events would include the sale of fixed assets, such as property, plant, and equipment. Also included under “Other” would be licensing agreements and the sale of patents, if they were categorized as outside the normal course of business. Sometimes

Warren believes that they should be removed from any calculation of the company’s net earnings

Income before tax” is a company’s income after all expenses have been deducted, but before income tax has been subtracted.

Warren has always discussed the earnings of a company in pre-tax terms.

We shall explore his “equity bond” theory in much greater detail toward the end of the book.

If the remainder doesn’t equal the amount the company reported as income taxes paid, we had better start asking some questions.

First on Warren’s list is whether or not the net earnings are showing a historical upward trend.

it is possible that a company’s historical net earnings trend may be different from its historical per-share earnings trend.

Share repurchase programs will increase per-share earnings by decreasing the number of shares outstanding.

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.

A fantastic business like Coca-Cola earns 21% on total revenues, and the amazing Moody’s earns 31%, which reflects these companies’ superior underlying business economics.

A simple rule (and there are exceptions) is that if a company is showing a net earnings history of more than 20% on total revenues, there is a real good chance that it is benefiting from some kind of long-term competitive advantage.

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.

Per-share earnings are the net earnings of the company on a per-share basis for the time period in question.

While no one yearly per-share figure can be used to identify a company with a durable competitive advantage, a per-share earnings figure for a ten-year period can give us a very clear picture of whether the company has a long-term competitive advantage working in its favor.

consistency and an upward trend.

Now if we take all the assets and subtract all the liabilities, we will get the net worth of the business, which is the same as shareholders’ equity.

Assets minus Liabilities = Net Worth or Shareholders’ Equity

Current Assets, and All Other Assets.