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Durable Competitive Advantages through the Cash Flow Statement

August 23rd, 2010

5 Comments

This is part three of Identifying Durable Competitive Advantages by Analyzing Financial Statements.

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

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.

How to Identify Competitive Advantage through the Cash Flow Statement

Capital Expenditures

  • 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.

Stock Buybacks

  • 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
SG&A
(SGA as % of gross profit)		< 30% is fantastic
Nearing 100% is in highly competitive industry		Consistency is Key
Depreciation
(depreciation costs as a % of gross profit)
Company with moat tend to have lower %
Interest Expenses
(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
(% net earnings to total revenues)		Net earnings history >20% = Long Term moat
< 10% = in highly competitive business		consistency and upward LT trend
EPS10-year period showing consistency and upward trend.
Avoid erratic earnings pictures.		Consistency = sign products don’t need to change.
Upward trend = strong
Balance Sheet
Cash and Equivalentslots of cash and marketable securities + little debtTest to see what is creating cash by looking at past 7 yrs of balance sheets
InventoryLook for an inventory and net earnings that are on a corresponding riseinventories that spike up/down are indicative of competitive industries prone to (boom/bust)
Net Receivablesconsistently shows lower % net receivables to gross sales than competitorsd.c.a. no need to offer generous credit
Goodwillincrease in goodwill over number of years assume because company out buying companies >BVd.c.a.’s never sell for less than BV
LT Investmentscan 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 AssetsInternally 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 Debtfinancial institutions. Buffett shies from those who are bigger borrowers of ST than LT debt
LT Debt Dued.c.a. need little or no LT debt to maintain operations
Total CL + Current Ratiohigher the ratio, the more liquid, the greater its ability to pay CLd.c.a.’s don’t need ‘liquidity cushion’ so may have <1
LT DebtLT 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 RatioIf <.80, Good chance company has d.c.a.
Preferred + Common Stockin search for d.c.a. we look for absence of preferred stock
Retained EarningsRate of growth of RE is good indicator
Treasury Stockpresence 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 equityd.c.a. show higher than average returns on shareholders equityIf 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 Expenditureshistorically 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 Buybacksindicator of d.c.a. is a history of repurchasing/retiring its sharesLook at cash from investment activities. “Issuance (Retirement) of Stock, Net”

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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  1. Identify Durable Competitive Advantages through the Income Statement
  2. Identify Durable Competitive Advantages through the Balance Sheet
  3. How to Master Analyzing the Cash Flow Statement
  4. Changes in Working Capital in Free Cash Flow FCF
  5. EBITDA or FCF to Measure Cash Flow

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  • http://www.allthingsannuity.com David Wilson

    Great post, thanks for the info as always.

  • http://www.devenir-rentier.fr Fabrice

    Terrific post! Thank you Jae.

  • http://thetreehole.blogspot.com Half Ben Half Phil

    Nice summary in the table above!

    I remember reading about some of the ideas from one of Mary Buffett’s booklet on reading financial statements.

    By saying “To assess: look at cash from investment activities. “Issuance (Retirement) of Stock, Net” ” You mean “from financing activities”, right? :-)