Warren Buffett And The Interpretation of Financial Statements

Mary Buffett

📚 GENRE: Business & Finance

📃 PAGES: 224

✅ COMPLETED: March 5, 2020

🧐 RATING: ⭐⭐⭐⭐

Buy Book

Short Summary

Mary Buffett reveals some of the strategies behind Warren Buffett’s success in the stock market. Mary Buffett explains what Warren Buffett typically looks for in a company and how to interpret financial statements.

Key Takeaways

1️⃣ Unique is Good — Companies that are unique have a chance to develop a durable competitive advantage, which is important to long-term success.

2️⃣ Earnings Drive Stock Movement — Earnings Per Share (EPS) is one of the biggest factors behind stock price movement. When a company beats analyst earnings estimates, its stock price normally soars. You want companies that have a bright future and are steadily growing EPS every year. 

3️⃣ Look at Cash Position — Cash is the lifeblood of a company. A company that is sitting on a pile of cash has a lot of options and flexibility at its disposal. 

Favorite Quote

"If you can’t read accounting documents and interpret financial statements, you shouldn't invest."

Book Notes 📑

Introduction

  • Warren Buffett looks for companies that have a long-term competitive advantage over competitors.
    • Buying these companies at a fair price and holding them for the long haul leads to nice gains over time. 
  • Quote: “If you can’t read accounting documents and interpret financial statements, you shouldn’t invest.” — Warren Buffett
    • Doing your homework is important to successful investing. Learning how to read financial statements is a valuable skill that allows you to evaluate companies. 

Chapter 1

  • In the 1960s, Buffett slightly altered the investment strategies he learned under Benjamin Graham, who he was partners with for a long time.
  • This book goes over Buffett’s big revelations:
    • How to identify an exceptional company with a durable competitive strategy.
    • How to value a company with a durable competitive advantage.

Chapter 2

  • When studying the financial statements of great companies, Buffett began to see why some of these companies had such a competitive advantage.
    • If Buffett decided this competitive advantage could be maintained over the long term, he kept the stock for the long-haul.
  • Buffet also discovered that companies with a competitive advantage had economic conditions working in their favor so much that the risk for bankruptcy was tiny.
  • The common belief is that you have to increase your risk to increase your potential to make money in the stock market.
    • The key is to identify great companies, pay a fair price for them, and hold them for the long haul.

Chapter 3

  • Great companies with a durable competitive advantage come in three basic business models:
    1. They sell a unique product.
      • Ex. Coke, Pepsi, Budweiser
      • These types of companies, through customer need and experience, and through smart advertising, have effectively placed the story of their products in our minds.
        • Buffett calls this “owning a piece of the customers mind.”
          • When this occurs, a company never has to change its products, which is a great thing.
          • The company can also sell its products for more money.
    2. They sell a unique service.
      • Ex. H&R Block, American Express, Wells Fargo
      • Firms that sell services that “own a piece of the consumers mind” can make bigger profits than those that sell products because providing services is normally a bit cheaper.
    3. They are a low-cost buyer or seller of a product or service that the public consistently needs.
      • Ex. Walmart, Costco
      • With these types of companies, big margins are traded for volume.

Chapter 4

  • The durability of a competitive advantage is key.
    • Ex. Coke — They’ve sold the same product for over 100 years. 
    • If the company doesn’t have to keep changing its product, it can spend less money on research and development.
    • When the cash piles up, the company doesn’t have to lean on debt too much, which means it won’t have to pay much interest, which means it can spend money towards expanding operations or towards share buybacks, which drives up earnings per share and the price of the stock, which makes shareholders happy. 
  • Buffet looks for consistency in the following areas when analyzing financial statements:
    • Does the company consistently have high gross profit margins?
      • Gross Profit Margin = Total revenue – COGS. 
    • Does the company consistently carry low debt?
    • Does the company consistently spend low amounts on research and development?
    • Does the company show consistent earnings? 
    • Does the company show consistent growth in earnings?

Chapter 5

  • Financial Statements — Income Statement, Balance Sheet, Statement of Cash Flows.
    • Income Statement — How a company performed over a given year. Begins with total revenue and subtracts expenses until a net profit figure is arrived at.
    • Balance Sheet — A snapshot of the company’s financial health at a given point in time.
    • Cash Flow Statement — Tracks the cash that flows in and out of the company.

Chapter 6

  • MSN.com or Yahoo.com are the best place to see financial statements.
  • The company’s annual 10k report can also be found on the SEC website (Edgar.com).

Chapter 7

  • The income statement shows performance for a company over a set period of time, most commonly a year.
  • Income statements feature three big categories:
    1. Revenue
    2. Expenses
    3. Net Income

Chapter 8

  • Total Revenue/Sales — How much a company sold
  • Total Revenue – Expenses = Net Income

Chapter 9

  • COGS — Cost of Goods Sold
    • What it costed the company to produce the products that were sold.
    • The lower the better. Lower COGS will mean greater gross profit margin. 

Chapter 10

  • Gross Profit = Total Revenue – COGS
  • Gross Profit Margin = Gross Profit / Total Revenue. 
    • This will be a percentage. 
  • Labor and raw materials are included in COGS.
    • COGS does not include sales and administrative costs, depreciation, and interest costs. 
      • Those items are subtracted in the following lines (operating expenses) as you go down the income statement.
  • Consistently high gross profit margins have led to better success for most companies.
    • Ex. Coke — Consistently produces 60% or better gross profit margins.
    • Ex. United Airlines — 14% gross profit margin. Bad.
    • Ex. Microsoft — 79%
    • Ex. Apple — 33%
  • A durable competitive advantage leads to a higher gross profit margin because these companies can sell their products and services at prices well above their COGS.
    • Without the durable advantage, companies have to lower their prices to compete, which reduces their gross profit margin.
  • Look for companies with a gross profit margin of at least 40%.
    • A gross profit margin of 20% or lower means this company is in a very competitive industry where everyone is competing and lowering their prices.
  • Track gross profit margin for the last 10 years to see how consistent a company has been with their gross profit margin.
  • High research and development, sales and administrative, and interest on debt costs can negate a healthy gross profit margin.
    • These are called operating expenses and can be a pain.

Chapter 11

  • Operating Expenses — Research and development, selling and administrative costs, depreciation and amortization, restructuring, etc. 
  • Gross Profit — Operating Expenses = Operating Income

Chapter 12

  • Selling & Administrative Expenses — Where a company reports direct and indirect selling expenses of producing and selling the product.
    • These expenses include management salaries, associate salaries, advertising, travel cost, legal fees, etc.
  • Coke consistently spends 59% of its gross profit on selling, general, and administrative expenses.
  • Companies that do not have a competitive advantage vary widely in their selling, general, and administrative (SGA) costs.
  • The lower the SGA costs in relation to total revenue, the better.
    • Anything under 30% is great.
    • 30-80% is OK.

Chapter 13

  • Research and development is very big when analyzing companies.
    • Ex. Moody’s, the bond rating company, is a favorite of Buffet’s because they don’t have to spend anything on research and development. Plus the company spends just 25% of gross profit on SGA. 
  • Buffet does not like a high research and development cost because it means the company doesn’t really have a competitive advantage and therefore needs to do a lot of research and development to invent new products.
    • Buffet is usually looking for companies that have a standard product that seems to sell well consistently. 

Chapter 14

  • Depreciation — The wearing out of a company’s buildings and machinery. A company is allowed to account for wear and tear over the property’s lifespan. 
    • Depreciation is measured and used as a cost against income in a given year. It essentially lowers taxable income.
    • Ex. A company buys a printing press for $1 million. The machine has a 10-year lifespan. For the next 10 years, the company logs a $100,000 depreciation expense on the income statement for the machine.
      • On the balance sheet, $1 million comes out of cash and $1 million goes into plant and equipment because you’ve just acquired a new machine.
        • Then, for the next 10 years, $100,000 will show up on the income statement as an expense and $100,000 will be reduced from the Plant and Equipment category and placed into “accumulated depreciation” (also on the balance sheet) each year as this is all occurring. 
  • Buffett believes depreciation is a very real expense and should be looked at closely when analyzing a company.
  • Good companies tend to have a lower percentage of depreciation eating away at gross profit than its competitors.
    • Ex. Coke — 6% 
    • Ex. GM — 22-52%

Chapter 15

  • Interest Expense — Found on the income statement and measures the interest a company paid on its debt, which is found on the balance sheet.
    • This is a financial expense, not an operating expense.
  • Companies with a durable competitive advantage normally have little to no interest expense because they’re not taking on a lot of debt.
    • Ex. Proctor and Gamble — 8%
    • Ex. Goodyear Tire — On average 49%

Chapter 17

  • Income Before Tax — A company’s income after all expenses have been deducted but before income tax has been subtracted. 
    • This is the number Buffett pays most attention to on the income statement.

Chapter 19

  • Net Income — What a company earned after expenses and all taxes have been deducted.
  • The first thing Buffett considers when looking at net income: Is the company showing an upward historical trend in net income?
    • Is there a consistent upward trend in net earnings?
  • Net earnings or net income is a better number to analyze than earnings per share because companies can manipulate the per-share earnings by buying their own stock and inflating the number by reducing the number of shares outstanding in the market.
  • Good companies report a higher percentage of net income to total revenue than their competitors.
    • Ex. A company with $2 billion in net earnings on $10 billion in total revenue is better than a company with $5 billion of net earnings on $100 billion in total revenue.
      • This comes out to earning 20% on total revenue for Company 1 vs. 5% on total revenue for Company 2.
    • Ex. Coke — On average, earns 21% on total revenue.
    • Ex. Southwest Airlines — 7%. Southwest is in a highly competitive airline industry where nobody really pulls away from the pack.
  • As a general rule, if a company is earning 20% or more on total revenue, there’s a good chance it is benefiting from a long-term competitive advantage.
    • Under 10% signals that the company is in a highly competitive industry.

Chapter 20

  • Per-Share Earnings — The net earnings of the company on a per-share basis.
    • If a company can steadily increase per-share earnings and beat analyst expectations, the stock price usually soars.
    • Per-share earnings is one of the biggest factors in a stock’s movement.
  • Per-share Earnings = Net Income / Number of Shares Outstanding
  • Look at per-share earnings over at least a 10-year period. Find out if the number is consistent and trending upward.

Chapter 21

  • Balance Sheet — A snapshot of a company’s assets and liabilities. The balance sheet will tell you how much cash and debt a company has.
  • Assets — Cash, receivables, inventory, plant and equipment.
  • Liabilities and Shareholders’ Equity — Current and long-term liabilities.
    • Current — What is owed in the current year.
    • Long-Term – Due in one year or more.
  • Net Worth — Total Assets – Total Liabilities.

Chapter 24

  • Cash & Cash Equivalents — You want to see this number high. A surplus of cash gives the company an opportunity to invest it and make even more. The company can also use the surplus to expand, invest, pay dividends, and more.
  • A company can sell bonds to make cash. It can also sell assets to make cash. But ideally, a company will have a high cash number because it is making more than expense.
  • High cash and low debt mean a company can survive tough times.
    • Look at the last 7 years to see if cash is consistently high. If so, the company is operating very well.

Chapter 26

  • Receivables — Cash that is owed to a company.

Chapter 27

  • Prepaid Expenses — A product or service coming to a business soon.
    • Think of these as a subscription to Sports Illustrated. You pay for the subscription ahead of time and then get the service over the next 12 months.

Chapter 28

  • Current Ratio = Current Assets / Current Liabilities 
  • The higher the current ratio, the more liquid the company is. This means it can pay off liabilities faster.
    • Over 1 is good. Below 1 is usually not too good.

Chapter 34

  • Return on Assets = Net Income / Total Assets 
    • Ex. Coke — $43 billion in assets, return on assets of 12%.

Chapter 35

  • Current Liabilities — What a company owes within a year.

Chapter 36

  • Accounts Payable — Money owed to suppliers after paying for a product or service from those suppliers using credit.
  • Accrued Expenses — Liabilities a company has accrued but has not been invoiced for.

Chapter 37

  • Short-Term Debt — Debt that is due by the end of the year.
    • Stay away from companies that accumulate a lot of short-term debt over long-term debt.
      • Short-term borrowers are at the mercy of shifts in the credit markets.

Chapter 38

  • Good, durable companies usually don’t have a lot of long-term debt.

Chapter 39

  • Current Ratio = Total Liabilities / Total Assets
    • A higher ratio means the company is more liquid, meaning it can better pay its liabilities when they come due.
      • Over 1 = Good
      • Below 1 = Not great 
        • Under 1 means a company might have trouble paying its creditors.
    • This number isn’t great for analyzing companies because a business with really good operations can still be under 1 on the current ratio and still thrive.

Chapter 40

  • Good companies don’t really have a lot of long-term debt.
    • This is because they make a lot of money and can basically finance their own operations. They don’t need to borrow and take on substantial debt.

Chapter 42

  • Total Liabilities — The sum of all the liabilities a company has.
  • Debt to Equity Ratio = Total Liabilities / Shareholders Equity
    • The debt to shareholders equity ratio route reveals if a company is using debt or equity to finance the company.
      • Good companies use more equity and less debt.
      • Bad companies use less equity and more debt.
  • Banks borrow a lot of money at a certain rate then loan it out at a higher rate and profit off of the spread in rates. 
    • This is why the debt/equity ratio is very high with banks.

Chapter 43

  • Assets – Liabilities = Net Worth aka Shareholders’ Equity

Chapter 44

  • Equity — The money that a company makes off selling common and preferred stock.
    • It never has to be paid back because it is not borrowed money. 
  • Common Stock — Ownership of the company. Partial ownership.
  • Preferred Stock — Investors get a special dividend and they get paid first if a company goes bankrupt. It is not ownership.
  • Preferred and common stock are carried on the balance sheet at “par value.”
    • Any money above that paid by investors goes to “paid in capital” on the balance sheet.
      • Ex. Preferred stock at $100 per share. The $100 will be listed under preferred stock, but if investors paid $120 per share, the $20 will be listed under “paid in capital.”

Chapter 45

  • Net earnings can be used to pay dividends, buy back shares, or be retained to be reinvested into the company and help it grow.
    • Retained money is listed on the balance sheet under retained earnings.
  • Retained Earnings is one of the most important figures to look at on the balance sheet.
    • It is the number that’s left after subtracting dividends paid and stock buybacks from net earnings. In other words, it’s what’s left over and it accumulates year after year.
  • Retained earnings is an accumulated number.
    • Over the years, the retained earnings number keeps stacking up.
    • If a company is not making additions to its retain earnings each year, it is not growing its net worth and is not worth investing in.
      • Ex. Coke — Grows its retained earnings by about 8% annually.
      • Ex. Berkshire Hathaway — 23%.
  • When a company acquired another company, the retained earnings are combined.

Chapter 46

  • When a company buys back its own shares it two options:
    1. Eliminate those shares
    2. Hold onto it with the idea of re-issuing it later
      • When a company holds it, it is listed on the balance sheet as “treasury stock.”
  • Because a good, durable company will make a lot of extra money, it will likely buy back its own shares and therefore have a good amount of treasury stock.

Chapter 47

  • Shareholders’ Equity is very important. It’s important to see how a company is using its money.
    • This number shows how well management is making decisions. It shows how well the money is being put to use. 

Chapter 48

  • Return on Shareholders’ Equity = Net Earnings / Shareholders’ Equity
    • Good companies have a higher return on equity.
      • Ex. Coke — 30%
      • Ex. United Airlines — 14%
    • A high number here means that the company is making good use of the money it is retaining.
      • Over time, the return on equity will add up, leading to better share prices.
  • Look for consistency and gains in net earnings and return on shareholders’ equity.

Chapter 49

  • Leverage is the use of debt to improve earnings.
    • Banks especially use a lot of debt.
    • Avoid companies that use a lot of debt.

Chapter 50

  • Accrual Method of Accounting — Sales are booked when goods go out the door, even if the buyer takes years to pay.
  • Cash Method of Accounting — Sales are only booked when cash comes in.
    • Most companies use the accrual method. This means it can sometimes be tough to keep track of cash.
      • This is why the cash flow statement was born. It keeps track of the cash flowing in and out of the company. 
  • The Cash Flow Statement — Has three categories.
      1. Cash flow from operating activity 
      2. Cash flow from investing activity 
      3. Cash flow from financing activity 
    • Add the three categories together to get the change in cash for the period.

Chapter 51

  • Capital Expenditures — Stuff like property, plant, and equipment held for over a year.
    • Assets that are expensed for over a year through depreciation and amortization.
  • A high capital expenditures number is bad. It means a company is spending a lot on long-term assets to keep up with competition. 
    • And it usually requires a lot of debt to makes these purchases. 
  • Look at capital expenditures in relation to net earnings over a 10-year period. 
    • Good companies use smaller percentage of net earnings on capital expenditures.
      • Ex. Coke — 19%
      • Ex. Moody’s — 5%
      • 50% or less is good. Less than 25% is great. 

Chapter 52

  • Stock Buyback — Reduces outstanding shares in the market, which increases shareholders’ ownership interest in the company and increases the stock’s earnings per-share number, which will make the stock price go up.
    • Buybacks essentially increase a shareholder’s wealth without issuing dividends, which are taxed twice – at the company level and at the individual level.

Chapter 57

  • Hold on to companies with a durable competitive advantage for as long as possible.
  • The more you sell, the more taxes you have to pay.
  • If you’re going to sell, sell in a bull market.Â