Identify Durable Competitive Advantages through the Income Statement

Isn’t it awesome how the internet has evolved so that your web of connections can expand although you’ve never met the person?

It’s fantastic how people email me with a common interest in investing and we can immediately pick up a conversation like we’ve been friends for ages.

Frank recently emailed me with some comments and we got to discussing about investing, BOLT, his take on valuation methods and also has graciously allowed me to edit his notes on Durable Competitive Advantages (DCA) and the set of criteria he uses to identify companies with durable competitive advantages.

Part one: Finding Durable Competitive Advantages by Analyzing the Income Statement

Part two: Finding Durable Competitive Advantages through the Balance Sheet

Part three: Finding Durable Competitive Advantages through the Cash Flow Statement

Finding Durable Competitive Advantages

The concepts that you find in this article is from the book Warren Buffett and the Interpretation of Financial Statements and addresses Warren Buffett type investing ideas and methodology.

This is not a book review, but notes from the book to discussing and identify durable competitive advantages.

The Exceptional Company

The exceptional company has a durable competitive advantage differentiated by the following:

• Unique product/service
• Low cost buyer AND seller of a product which public needs consistently

The exceptional company has durability.

• Consistency in product = consistent profits
• Consistent: high gross margins / low debt / low R&D exp. /strong earnings / earning growth

Analyzing the Income Statement

When it comes to analyzing the income statement, it is important to investigate further and drill down to detect what the quality of earnings are made up of and what the numbers interpret.

Revenue: Analyze expenses

Cost of Goods Sold:  investigate what the company includes

Gross Profit Margin: firms with excellent long term economics tend to have consistently higher margins

• Durable competitive advantage creates  a high margin because of the freedom to price in excess of cost
• Greater than 40% = Durable competitive advantage
• Less than 40% = competition eroding margins
• Less than 20% = no sustainable competitive advantage
• CONSISTENCY is KEY

SG&A: Consistency is key.

Companies with no durable competitive advantage show wild variation in SG&A as % of gross profit

• Less than 30% is fantastic
• Nearing 100% is in highly competitive industry

R&D: if competitive advantage is created by a patent or tech advantage, at some point it will disappear.

• High R&D usually dictates high SG&A which threatens the competitive advantage

Depreciation: Using EBITDA as a measure of cash flow is very misleading

• Companies with durable competitive advantages tend to have lower depreciation costs as a % of gross profit

Interest Expenses: Companies with high interest expenses relative to operating income tend to be either:

1) in fiercely competitive industry where large capital expenditure required to stay competitive

2) company with excellent business economics that acquired debt in leveraged buyout

• Companies with durable competitive advantages often carry little or no interest expense.
• Warren’s favorites in the consumer products category all have less than 15% of operating income.
• Interest expenses varies widely between industries.
• Interest ratios can be very informative of level of economic danger.

Rule: In any industry, the company with the lowest ratio of interest to Operating Income is usually the one with the competitive advantage.

Gain (Loss) Sale Assets and “Other”: For non-recurring income or losses, remove from calculations of net earnings

Income Before Tax: Buffett uses this number when calculating his return. It allows for comparison with other investments types. E.g. Equity and bonds.

Income Taxes Paid: Helps figure out who’s window dressing

• Check SEC docs and see what they are paying in income tax.
• Take pre-tax operating income and deduct tax rate (USA 35%)
• Compare with reported income tax paid

Net Earnings

• Look for consistency and upward long term trend.
• Because of share repurchase its possible for net earnings trend to differ from EPS trend.
• Preferred over EPS
• Durable competitive advantage companies report higher % net earnings to total revenues.

Rule: If a company is showing net earnings history greater than 20% on total revenues, it is probably benefiting from a long term competitive advantage.

• If less than 10%, likely to be in a highly competitive business
• Exception – Banks and financial companies where abnormally high ratio of net earnings to total revenues usually means poor risk management.

Earnings Per Share (EPS)

• Look for at least ten-year period showing consistency and an upward trend.
• Consistent earnings is usually a sign that the company sells products that doesn’t need to go through costly process of change.
• Upward trend reflects the company is strong enough to allow it to make expenditures to increase market share through advertising and expansion.
• Or a company could use financial engineering like stock buybacks to increase EPS
• Avoid erratic earnings pictures

Next in the Series

Part two: Finding Durable Competitive Advantages through the Balance Sheet

About Jae Jun

Jae Jun has written 528 value investing articles.

Jae is the founder of Old School Value and has a mission to empower every investor by providing tools, tutorials and educational material so that they can invest successfully on their own.

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