This is part three of Identifying Durable Competitive Advantages by Analyzing Financial Statements.
Part three: Finding Durable Competitive Advantages through the Cash Flow Statement
The information provided in this article can be found in the book Warren Buffett and the Interpretation of Financial Statements.
Before you proceed, you may be interested in a primer on analyzing the cash flow statement.
Rule: company with durable competitive advantage uses a smaller portion of earnings for capital expenditure for continuing operations than those without.
Rule: if historically using less than 50%, then good place to look for durable competitive advantage. If less than 25%, probably has a competitive advantage.
Rule: history of repurchasing/retiring shares is an indicator of competitive advantage
Equtiy Bond Idea
|Income Statement||(DCA = Durable Competitive Advantage)||Comments|
|Gross Profit Margin||>40% = D.C.A.|
<40% = competition eroding margins
<20% = no sustainable competitive advantage
|Consistency is Key|
(SGA as % of gross profit)
|< 30% is fantastic|
Nearing 100% is in highly competitive industry
|Consistency is Key|
(depreciation costs as a % of gross profit)
|Company with moat tend to have lower %|
(interest expenses relative to operating income)
|Durable competitive advantage carry little or no interest expense.|
Buffett's favorite consumer products have <15%
|Company with lowest ratio of interest to Operating Income = competitive advantage.
Varies widely between industries.
(% net earnings to total revenues)
|Net earnings history >20% = Long Term moat|
< 10% = in highly competitive business
|consistency and upward LT trend|
|EPS||10-year period showing consistency and upward trend.|
Avoid erratic earnings pictures.
|Consistency = sign products don’t need to change.
Upward trend = strong
|Cash and Equivalents||lots of cash and marketable securities + little debt||Test to see what is creating cash by looking at past 7 yrs of balance sheets|
|Inventory||Look for an inventory and net earnings that are on a corresponding rise||inventories that spike up/down are indicative of competitive industries prone to (boom/bust)|
|Net Receivables||consistently shows lower % net receivables to gross sales than competitors||d.c.a. no need to offer generous credit|
|Goodwill||increase in goodwill over number of years assume because company out buying companies >BV||d.c.a.’s never sell for less than BV|
|LT Investments||can have valuable assets on books at valuation < market price (booked at lowest price)||tells us about investment mindset of management
(Looking for d.c.a.?)
|Intangible Assets||Internally developed brands not reflected on BS|
|Total Assets + ROA|
(Measure efficiency using ROA)
|Higher return the better (but: really high ROA may indicate vulnerability in durability of c.a.)||Capital = barrier to entry|
|ST Debt||financial institutions. Buffett shies from those who are bigger borrowers of ST than LT debt|
|LT Debt Due||d.c.a. need little or no LT debt to maintain operations|
|Total CL + Current Ratio||higher the ratio, the more liquid, the greater its ability to pay CL||d.c.a.’s don’t need ‘liquidity cushion’ so may have <1|
|LT Debt||LT debt load for last ten yrs. ten yrs w/ little LT debt = d.c.a.||earning power to pay their LT debt in <3/4 yrs = good candidates|
|Total Liabilities + Treasury Share-Adjusted debt to Shareholder Eq Ratio||If <.80, Good chance company has d.c.a.|
|Preferred + Common Stock||in search for d.c.a. we look for absence of preferred stock|
|Retained Earnings||Rate of growth of RE is good indicator|
|Treasury Stock||presence of treasury shares and a history of buyback are good indicators that company has d.c.a.||convert –ve value of treasury shares into +ve and add shareholder eq.
Divide net earnings by new shareholders eq. give us return on equity minus dressing.
|Return on Shareholder equity||d.c.a. show higher than average returns on shareholders equity||If company shows history of strong net earnings, but shows –ve sholder equity, probably d.c.a. because strong companies don’t need to retain|
|Cash Flow Statement|
|Capital Expenditures||historically using|
<50% then good place to look for d.c.a.
<25% probably has d.c.a.
|Add up total cap exp for ten-yr period and compare w/ total net earnings over period.|
|Stock Buybacks||indicator of d.c.a. is a history of repurchasing/retiring its shares||Look at cash from investment activities. “Issuance (Retirement) of Stock, Net”|