This is part three of Identifying Durable Competitive Advantages by Analyzing Financial Statements.
Part three: Cash Flow Statement Competitive Advantages
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.
Cash Flow Statement Competitive Advantages
- Never invest in telephone companies because of big capital outlays
Rule: company with durable competitive advantage uses a smaller portion of earnings for capital expenditure for continuing operations than those without.
- To compare capex to net earnings, add up total cap exp for ten-yr period and compare with total net earnings over the same period
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.
- Buyback increases EPS even though actual net earnings do not. More shares outstanding = lower EPS. Buybacks increase shareholder wealth without taxes.
- To assess: look at cash from investment activities. “Issuance (Retirement) of Stock, Net”
- If buying back consistently, the company has a competitive advantage because it is generating lots of cash
Rule: history of repurchasing/retiring shares is an indicator of competitive advantage
Valuing the Company With Durable Competitive Advantage
Equtiy Bond Idea
- A company with competitive advantage shows great strength and predictability in earnings growth, that growth turns the shares into a kind of equity bond, with an ever-increasing coupon/interest payment. (Bond=shares/equity. Coupon/interest payment = pretax earnings)
- e.g. In 1980 Buffett bought Coke for $6.50 a share against pre-tax earnings of $.70 a share = after-tax $.46. Historical earnings growth = 15%
- Buffett argues that he got a Coke bond paying initial pretax interest rate 10.7% on a $6.50 investment, with yield increasing at 15% annually.
Durable Competitive Advantage Summary
|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”|