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
[table id=17 /]