For the last few weeks I’ve been studying Buffettology as a way of investing, and as a result of reading several “Buffettology” books, this page contains all of my notes on reading financial statements and investing in stocks using the Buffettology philosophy. The notes in this post primarily come from theses books:
- Warren Buffett and the Interpretation of Financial Statements (abbreviated below as WBaIFS)
- The Buffettology Workbook
- The New Buffettology
- The Warren Buffett Way
Note that I have a related Warren Buffett Way cheat sheet (which is surprisingly different than this cheat sheet which is based on the Buffettology books), and at some point I’ll combine the two.
A great summary of Buffetology is that you should try to find companies with a durable competitive advantage; wait for a buying opportunity that Mr. Market presents to you; buy the company’s stock when you have a high degree of certainty that you can achieve a compounded annual growth rate of 15% or more.
In a related note, as one of the quotes below states, you should “Act as though you have a ‘lifetime decision card’ with just twenty punches on it.” This means that you shouldn’t expect to find dozens of companies like this every year, you might only find twenty in your lifetime, and you need to be ready to pounce when the opportunity presents itself.
Note that in the notes below the acronym DCA is used a lot, and it stands for Durable Competitive Advantage.
|Revenue||Total, gross revenue. The amount of money that came in the door during the time period of the statement.|
|Cost of Goods Sold||Also known as Cost of Revenue (for Services businesses).
Either the cost of purchasing the goods the company is reselling, or the cost of the materials and labor used in manufacturing the products it is selling. (Cost of raw goods and labor.)
Good example on p. 31 of (WBaIFS).
|Gross Profit||Gross Profit = Revenue - Cost of Goods Sold
Doesn’t include sales and administrative costs, depreciation, and interest costs.
Gross Profit Margin is more important than this raw number.
Companies with a DCA have consistently higher Gross Profit Margins (GPM).
DCA creates a high GPM b/c the DCA lets the companies more easily raise prices.
General rule: 40% or higher tends to be companies with a DCA. 20% or lower is a fiercely competitive industry.
A high GPM can still be messed up if the company has high R&D costs, high selling & administrative costs, or high interest costs on debt (operating expenses, next section).
|Operating Expenses||Costs associated with R&D, selling and admin costs of getting the product to market, etc., as listed below.|
|Selling, General & Admin.||Abbreviated as SGA.
All direct and indirect selling and G&A expenses.
Management salaries, advertising, travel, legal fees, commissions, all payroll costs.
Consistent == good (good management), inconsistent == bad.
Vary greatly by industry.
Anything under 30% is considered fantastic, but DCAs can still have 30-80%.
The higher the %, the more competitive the industry. If they’re consistently high, they have no DCA; avoid them.
What happens is that when sales fall, SGA expenses remain for a while; can’t be cut fast enough, or not seen.
|Research & Development||Patents — at some point they will expire (pharmaceuticals).
Merck spends 29% of Gross Profit on R&D and 49% on SGA.
Intel consistently spends 30% on R&D.
Moody’s and Coca-Cola have no R&D.
Rule: Companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long-term economics at risk, so they are not a sure thing.
|Depreciation||All machinery and buildings wear out over time.
The amount that something depreciates in a year is a cost that is allocated against income for that year.
Ex: A $1M printing press is depreciated $100K/year for 10 years. On the balance sheet that $1M may come out of cash on Year 1, and $1M is added to Plant & Equipment. For ten years $100K will be subtracted from Plant & Equipment, and $100K is added to Accumulated Depreciation Liability. $1M cash outlay in Year 1 shows up on Cash Flow statement under Capital Expenditures.
Wall Street schmexperts add the $100K depreciation back into earnings, but Buffett thinks that’s dumb b/c the equipment really is depreciating and their will be an eventual cost.
Companies with a DCA tend to have lower depreciation costs. Coca-Cola about 6%, Wrigleys 7%, PG 8%. GM is 22-57% of gross profits.
|Operating Profit||Operating Profit = Gross Profit - SGA - R&D - Depreciation
Also known as Operating Income.
|Interest Expense||Interest paid out on the debt the company carries on its balance sheet as a liability.
Call a “financial cost,” not an operating cost, so it’s listed separately.
Companies with a high % are either (a) in a fiercely competitive industry, or (b) a good company that acquired debt when the company was bought in a leveraged buyout.
DCAs often have little or no interest expense. PG is 8%, Wrigley is 7%; Goodyear is a whopping 49%.
Southwest is typically 9%, United is 61%, American was 92% of Operating Income.
Rule: DCAs in consumer products are less than 15% of Operating Income; but this varies greatly by industry; Wells-Fargo is 30%, but the lowest among banks.
Bear-Stearns was 70% and then shot up to 230% right before failing.
|Gain (Loss) Sale Assets||Sell something for a profit (loss). Includes depreciation.
Ex: Bought printing press for $1M, depreciated to $500K, sold it for $800K, gain=300K.
|Other||Just like Gain/Loss on Sales of Assets.
“Non-operating, unusual, and infrequent income and expense events.”
Includes sale of fixed assets such as property, plant, and equipment. Also licensing agreements and the sale of patents if they were categorized as “outside the normal course of business.”
Sometimes these can really affect the bottom line (but generally only for a year, not a recurring thing).
Buffett believes these items should be removed from any calculation of Net Earnings because they are unusual.
|Income Before Tax||Income after all expenses, but before income tax.
Buffett uses this number when he buys a whole business, and generally prefers this income number.
“Always discusses the earnings of a company in pre-tax terms.”
Includes an example of why he bought tax-free bonds one time.
|Income Taxes Paid||Should be 35% of Income Before Tax, but bad companies may attempt to fudge this.
Because of liars, this line reflects the company’s true pre-tax earnings.
|Net Earnings||This is the income after all expenses and taxes have been deducted from revenue.
For investing, look for a consistently increasing number over time. This is what makes a stock worth more in the long run.
Net Earnings is better than Earnings/Share (EPS) because EPS can change when a company buys its stock back (or issues more).
DCAs have a higher Net Earnings % than competitors.
Buffett prefers a small company with 20% here compared to a much larger company with 5%.
Coca-Cola is 21%, Moody’s is 31%, Southwest is only 7%, GM is 3%.
Rule: A history of 20% or more has a DCA. Under 10% is likely in a competitive industry without a DCA.
EPS: Companies with consistent earnings usually means that a company is selling products that don’t need to go through the expensive process of change.
The following table covers items that are found on a Balance Sheet. One thing to know:
Assets - Liabilities = Net Worth (or Shareholder’s Equity)
|ASSETS||Where all the goodies are kept: cash, plant, equipment, patents; all the stuff riches are made of.
Current Assets are cash and things that can be converted into cash (usually within a year).
They are listed on the balance sheet in order of liquidity (how quickly they can be turned into cash).
All other assets are not considered current.
Current Assets are referred to as “Working Assets” because they are in the cycle of Cash → Inventory → Accounts Receivable → Cash.
Cash Flow Cycle: Cash → Buy parts/goods → Make products → Inventory → Sell or ship to resellers → Accounts Receivable → Cash
|Cash & Short-Term Investments||Cash, short-term CDs, three-month treasuries, or similar.
High number: Either (a) generating a lot of cash or (b) just sold a business or a ton of bonds, which may not be good things.
Low number: Generally not good.
If you’re earning a lot more than you’re spending, cash piles up.
Then you have to figure out what the best thing to do with all that cash is.
Excess cash: But new businesses, buy back shares, pay out cash dividend, or sock it away for a rainy day.
Companies have three ways of creating a big stockpile of cash: (1) Sell new bonds or equity; (2) sell an existing business or assets; (3) Great ongoing business, indicating a DCA.
If a company is facing a short-term problem, Buffett looks at cash or “marketable securities” the company has hoarded away to see if they can weather the storm.
Rule: If they don’t have much cash and have a mountain of debt, it’s a sinking ship.
Test: Look at least seven years of balance sheets. This will tell you where a cash hoard has come from, i.e., sale of new bonds or shares, or ongoing business.
DCA: Lots of cash, little or no debt, consistent earnings, no sales of bonds or shares.
Cash is king when trouble hits.
|Total Inventory||The company’s products that sit in a warehouse waiting to be sold to vendors or customers.
Refers to the inventory on the day of the Balance Sheet.
Some inventory ages poorly (old CPUs); for DCAs it’s not as big a deal b/c products never change.
To identify a manufacturing company with a DCA, look for Inventory and Net Profits that are rising together.
If inventory ramps up and down over years, it’s probably a competitive boom/bust industry.
|Total Receivables, Net||You ship products to vendors, they typically pay Net-30. The company is essentially giving the vendor credit for that time period.
Some vendors won’t pay (Trump declaring bankruptcy), so Bad Debts are deducted from Receivables to get Net Receivables.
In very competitive industries some companies will try to gain an advantage by offering Net-60 or Net-120. This causes an increase in Revenue and Receivables.
If a company shows a % or Net Receivables to Gross Sales that is lower than its competitors, it usually has a competitive advantage related to its competitors.
|Prepaid Expenses||Pay for good and services they will receive in near future.
They’ve been paid for and not yet received, so technically they are assets.
Ex: Insurance premiums for the year ahead.
|Other Current Assets, Total||(not described)|
|Total Current Assets||Current Ratio = Current Assets / Current Liabilities.
Greater than 1 is good, below 1 is bad (generally).
But Moody’s is 0.64, Coca-Cola is 0.95, PG is 0.82.
Because these companies have great earnings power they can pay out dividends, repurchase stock, both of which diminish cash and pull their Current Ratio down. But they have consistent earning power, so it’s not a problem.
|Property, Plant, Equipment||Property, manufacturing plants, and equipment, at their original cost, less accumulated depreciation.
Two years in, the printing press will be listed at $800K ($1M cost less $200K depreciation).
No-DCA companies must constantly update equipment to stay competitive.
A company with a DCA doesn’t need to constantly upgrade its plant and equipment to stay competitive. (Coca-Cola, Wrigley.)
A company with a DCA can pay for its own equipment with Cash, others will need to finance Debt.
Wrigley has $1.4B in equipment, $1B in debt, profits $500M/year.
GM has plant and equipment of $56B, $40B in debt, and had no profit for two years.
Buffett: Producing a consistent product that doesn’t have to change equates to consistent profits.
|Goodwill, Net||When Exxon buys XYZ Company at a price in excess of Book Value, the excess is recorded on Exxon’s balance sheet under Goodwill.
Buy a lot of companies like that and end up with a lot of Goodwill here.
When you see an increase in Goodwill over a period of years you can assume that’s because they’re buying other businesses.
If the amount stays the same over the years it’s b/c they’re paying less than book value for businesses or aren’t making acquisitions.
AAPL goodwill has increased from 5.1B to 5.7B in three years.
MSFT has doubled in three years from $16.9B to $35.1B
CELG hasn’t increased in three years, but it should when their purchase of Juno goes through.
|Intangibles, Net||Things you can’t physically touch.
Patents, copyrights, trademarks, franchises, brand names.
Companies used to water the balance sheet with fantasy values for intangible assets.
In an asset has a finite life (like a patent) it’s amortized over the course of its useful life.
Companies like Coca-Cola, Wrigley, McDonald’s have a great asset in their company name/brand, but it isn’t recognized as an asset on a balance sheet. This is one way a DCA’s value is kinda-sorta hidden.
|Long-Term Investments||Longer than a year, things like stocks, bonds, and real estate.
Investments in affiliates and subsidiaries.
Carried on the books at cost or market price, whichever is lower.
Long-term investments can speak about management’s mindset. Do they invest in other businesses that have DCAs (good)? Or other non-DCA businesses (bad)? (Sometimes poor managers will buy non-DCA businesses because they’re bored, or want to do something to prove they’re managing something, which is bad.)
|Other Long-Term Assets||A giant pool of assets that have lives greater than a year that don’t fit in the previous categories.
Ex: Pre-paid expenses and tax recoveries that will be received in future years.
(Not an important category when looking for DCA businesses.)
|TOTAL ASSETS||If a company has $40B in assets, they arguably have a really big moat. Other businesses can’t easily raise that kind of money. “Capital is a barrier of entry to any business.”
Coca-Cola has $43B in assets and an ROA of 12%.
PG has $143B in assets and an ROA of 7%.
Altria has $52B in assets and an ROA of 24%.
Moody’s has $1.7B in assets (small moat and therefore smaller DCA) and 43% ROA.
|Accounts Payable||Money owed to suppliers that have provided goods and services on credit.
Ex: Apple gets $1B in chips from Intel, and gets a Net-30 invoice at that time.
|Accrued Expenses||Liabilities that have been incurred, but have not yet been invoiced for.
Ex: Sales tax payable, wages payable, rent payable.
|Short-Term Debt||Owed within a year.
Ex: A short-term loan for 5% on $10M.
Smartest way to make money in banking is to borrow it long term and lend it long term.
See pages 110-111 for information on banks like Wells Fargo and Bank of America.
|Long-Term Debt Due||Technically not due for a year, but very large corporations may have some long term debt come due on a yearly basis.
Rule: DCAs require little or no long-term debt.
|Other Current Liabilities||Slush fund for debts that don’t fall into previous categories.|
|Total Current Liabilities||A Current Ratio > 1 is good, less than that is bad (generally). (Search this page for contrary examples.)|
|Long-Term Debt||Debt that matures any time past one year.
DCAs have very little in this category. They are so profitable they are self-financing.
F and GM will have a lot of this.
Note that DCAs are often targets of leveraged buyouts where buyers borrow against the company’s cash flow (p. 119).
|Deferred Income Tax||Tax that is due but hasn’t been paid.|
|Minority Interest||Berkshire bought 90% of Nebraska Furniture Mart.
Because it bought more than 80%, it could put 100% of NFM’s income on their income statement, and add 100% of NFM’s assets and liabilities to its balance sheet.
“Minority Interest” represents the value of the 10% Berkshire doesn’t own. Shows up as a liability b/c Berkshire listed 100% of assets and liabilities, even though it only owns 90%. (Story on pages 120-121.)
Not much to do with DCA.
|Other Liabilities||Catch-all line item for miscellaneous items: Judgments against company, non-current benefits, interest on tax liabilities, unpaid fines, more.|
|TOTAL LIABILITIES||Sum of all liabilities.
Helps give us “Debt to Shareholder’s Equity Ratio,” which can help find a DCA (with a few modifications).
This ratio historically helped to identify whether a company is using debt to finance its operation or Equity, which includes retained earnings.
A DCA should have high Shareholder Equity and low Debt, so Debt/ShareholderEquity should be very low.
Equation: Debt/ShareholderEquity == TotalLiabilities/ShareholderEquity.
A problem with this is that DCAs have such great earning power that they don’t need a large amount of Equity (Retained Earnings) on hand.
Rule: Unless you’re looking at a financial institution, if you see an adjusted Debt/ShareholderEquity ratio below 0.80 (the lower the better), there’s a good chance the company has a DCA.
TODO: NEED TO WRITE ABOUT THE “ADJUSTED” PART.
|Shareholder’s Equity||Assets - Liabilities = Net Worth == Shareholder’s Equity == Book Value
The amount the owners/shareholders put into the business and have left in the business to keep it running.
Lets us calculate “Return on Shareholder’s Equity” (ROE).
Note: “equity” generally means “stock,” both preferred and common stock. This money never has to be paid back.
Bonds, on the other hand, are borrowed money.
|Preferred Stock||Have a right to a fixed or adjustable dividend that must be paid before common stock owners receive their dividend.
Also have priority if the company falls into bankruptcy.
Interestingly they have no voting rights.
Companies with a DCA tend not to have Preferred Stock, b/c they don’t have debt.
|Common Stock||Have the right to elect the Board of Directors.|
|Additional Paid in Capital||Related to common and preferred stock.
Ex: If the company’s preferred stock has a par value of $100/share and it sold to the public at $120/share, $100/share is carried on the books under Preferred Stock and $20/share is carried under Paid In Capital.
|Retained Earnings||Net Earnings (Profit) can either (a) be paid out as dividends, (b) used to buy back shares, or (c) be retained to keep the business growing.
When they are retained, they’re shown here.
Profitably put to use, they can be used to grow the company.
Berkshire retained net earnings (forever, I think), which increased share prices from $19 in 1965 to $78,000 in 2007.
|Treasury Stock - Common||When a company buys back its stock it can (a) retire the stock or (2) retain it, with the possibility of reissuing it.
The second category is known as Treasury Stock.
They’re carried on the balance sheet as a negative value b/c they represent a reduction in shareholder equity.
Companies with DCA buy back their own stock, so an indicator of a DCA is having treasury stock. (AAPL and MSFT do not have any of this at this time.)
Rule: Seeing a number here along with recent buybacks is a good thing.
Note: Has an effect on the calculation of equity. See p. 137 if this is important.
|TOTAL SHAREHOLDER’S EQUITY||Assets - Liabilities = Shareholder’s Equity == Net Worth
Equity comes from three sources: (1) Capital raised from originally selling preferred and common stock to the public; (2) later sales of preferred and common stock; (3) accumulation of retained earnings.
All equity belongs to the company, which belongs to the common shareholders, so it’s called Shareholders’ Equity.
“Return on Shareholders’ Equity” (ROE) is an important metric which tells us how good/smart management is. If they retain their earnings and buy other DCAs, that should show up in this number.
Equation: ROE = Net Earnings/ShareholdersEquity
Some companies are so profitable, they don’t need to retain any earnings, so they pay them out to shareholders as dividends; in this case, shareholder equity can be a negative number. Unfortunately really bad companies will also have a negative number.
High ROE means “come play,” Low ROE means “stay away.”
- ROE = Net Earnings / Shareholders’ Equity
- DCAs have higher than average ROE
- Ex: Coca-Cola=30%, Wrigley=24, Hersheys=33, Pepsi=34 (44 this year)
- Some companies are so profitable, they don’t need to retain any earnings, so they pay them out to shareholders as dividends; in this case, shareholder equity can be a negative number. If the company has a strong history of large net earnings but negative shareholders’ equity it probably has a DCA.
- Leverage is the use of debt to increase business earnings. The company borrows $100M at 7% and puts it to work, hoping to make 12%.
- That means it earned 5% in excess of its capital costs. Adds $5M to bottom line, which increases earnings and ROE.
- Problem is, it can appear that the company has a DCA (because it inflates ROE), when in fact it’s really just using debt.
- Wall Street banks are notorious for this practice, borrowing $100B at 6% and lending it at 7%.
Cash Flow Statement
- Since the Accrual Method lets sales that were made on credit to be booked as revenue, it becomes necessary to keep track of actual cash flows in and out of the company.
- Can have a lot of sales on credit and not have any cash flowing in.
- This statement tells you if there is positive or negative cash flow.
- Like the Income Statement, the Cash Flow Statement always covers a set period of time.
|Cash Flows from Operating Activities||Start with Net Income (Net Earnings) and add back in Depreciation and Amortization.
Though these are real expenses, they don’t eat up any cash.
“Operating Activities” means what you do for business on a regular basis.
|Net Income||“Net Earnings” on the Income Statement.|
|Adjustments to Net Income||Discussed above (kinda).|
|Changes in Accounts Receivables|
|Changes in Liabilities|
|Total Cash Flow from Operating Activities|
|Cash Flows from Investing Activities|
|Capital Expenditures||Always a negative number because it’s an expense that causes a depletion of cash.
Buying permanent things: property, plants, and equipment.
Also expenditures for intangibles like patents. (Think GOOG buying Motorola for its patents.)
These are generally assets that are expensed for more than a year through depreciation and amortization.
(Buy a new truck, it’s a capital expense, and will be depreciated over six years. But its gas is a current expense.)
Buffett never invested in telephone companies because of the huge expenses.
Rule: DCAs have a smaller % of capital expenditures. (Coke and Wrigley don’t need to keep buying things the same way GM does.)
GM’s CapitalExpense/NetIncome was 444%, Goodyear was 950%. Where does that money come from? Bank loans and selling debt, which adds more debt to the balance sheet.
Buffett looks at this ratio from a ten-year perspective.
Examples: Wrigley=49%, Altria=20, PG=28, Pepsi=36, Coca-Cola=19, Amex=23, Moody’s=5.
50% or less is a good place to look for a DCA; 25 or less is very probable.
|Other cash flows from investing activities||All the cash that gets spent and brought in from the buying and selling of income-producing assets.
If more cash is spent than brought in, this is a negative number.
|Total Cash Flow from Investing Activities|
|Cash Flows from Financing Activities|
|Dividends Paid||Outflows of cash to pay dividends to shareholders.
“(3,149)” means that money was paid out.
Shareholders have to pay income tax on dividends, so Buffett doesn’t like to pay those.
|Sale Purchase of Stock
“Issuance (Retirement) of Stock, Net”
|Buying (and selling) of the company’s stock.
Buffett prefers buying back shares rather than issuing dividends. This increases shareholders’ wealth without them having to pay income tax.
When the company buys stock back, cash flows out.
When the company issues new stock to finance a new plant, cash flows in.
“(219)” means they bought back $219M.
A DCA buys back its shares.
“Issuance (Retirement) of Debt, Net”
|“4,341” means they sold that much new debt (bonds?).|
|Other cash flow from Financing Activities|
|Total Cash Flow from Financing Activities|
|Effects of Exchange Rate Changes|
|Change in Cash and Cash Equivalents||The “net change in cash.”|
How to value a DCA Company
Notes from “Warren Buffett and the Interpretation of Financial Statements”
These are my notes from the book, Warren Buffett and the Interpretation of Financial Statements. There are a lot of good things in this book, as evidenced by the financial statement notes above, but these are other good notes from that book.
- “Durable Competitive Advantage” is mentioned about 100 times.
- Consumer Monopoly vs Commodity is also stressed a lot.
Notes from The Buffettology Workbook
The best information from the book, The Buffettology Workbook:
- Buy “Consumer Monopolies,” don’t buy Commodity businesses
- Consumer Monopolies:
- Like a toll bridge, you have to buy it from them
- Would it be possible to compete with this company?
- Quality and uniqueness are most important factors to buyers
- High ROE
- Strong brand name product or key service
- If the company is a monopoly you can project the future price of the stock using the company’s per-share annual growth rate
- “Sick” Commodities:
- Low profit margin
- Low ROE
- Competitive — multiple producers of the product
- Erratic profits
- May have to keep investing capital in plants/facilities to stay competitive
- For a company to make shareholders rich over the long run:
- It must have high ROE
- Must be able to retain earnings and not have to spend it all on maintaining current operations
- A 10-year summary of EPS will tell a lot about a company
- Look for strong, growing EPS (not wild fluctuations)
- Company earnings:
- If the company earned $5/share and you own 100 shares, you earned $500
- If you paid $25/share and it earned $5/share, your initial rate of return is 20%
- The price you pay determines your return (it’s the denominator in that equation)
- To grow EPS, management must employ retained earnings intelligently
- Over time increased EPS will increase the stock’s price
- All investments compete for your money
- Think of the Treasury Bond as competing with the return paid on other investments
- Think of a share of stock as a type of equity/bond in which the EPS can be thought of as the equity/bond yield
- But, the yield varies each year; if it continuously increases that’s a good thing
- If you can’t confidently predict the earnings for the company for ten years, look at other investment opportunities
- After you estimate future earnings, you can estimate the future stock price using the average P/E ratio for the last ten years
- The coupon/bond analogy is important to the process
- “If I pay X for a share of stock, given the economic realities of the business, what is my expected annual compounding rate of return going to be in ten years?”
- In this way you never have to worry about what price Mr. Market has been on the stock each day
- Companies buying back their stock:
- Increases EPS
- The pie is the same size, but the slices are larger. (Ex: Company with three owners; company buys out one owner, retires shares. The business earnings are still the same, but now they’re shared by only two owners, i.e., 50% each rather than 33%.
- Some share repurchases can mask poor performance; look at raw earnings in addition to EPS
- Companies that do a good job of allocating retained earnings will make their shareholders more money
- Look for a history of smart management
- Consumer monopolies naturally do a better job of allocating retained earnings
- Commodities are at a disadvantage because they have low margins and need to continually invest in equipment to stay in business (Intel, GE)
Investing terminology and definitions
|CAGR||Compound Annual Growth Rate
It can be thought of as the growth rate that gets you from the initial investment value to the ending investment value if you assume that the investment has been compounding over the time period. (link)
The mean annual growth rate of an investment over a specified period. (link)
CAGR = (EV/BV)^(1/n)-1, where EV = ending value, BV = beginning value, n = # of periods
|EPS - basic, diluted|
|Free Cash Flow (FCF)||OperatingCashFlow - CapitalExpenditures
The cash a company is able to generate after spending the money required to maintain or expand its asset base.
The excess cash can be used to expand production, develop new products, make acquisitions, pay dividends, and reduce debt.
(Think of it as cash they can put in a savings account.)
“How much cash flow exists beyond what is necessary to keep a firm operating at its current rate.” (link)
Future FCF needs to be discounted to a current/present value.
More from Investopedia:
- Calculated as operating cash flow minus capital expenditures
- FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base (all capital expenditures, such as buildings or property, plant and equipment)
- FCF is important because it allows a company to pursue opportunities that enhance shareholder value
- The excess cash is used to expand production, develop new products, make acquisitions, pay dividends and reduce debt
FCF is calculated as:
FCF = EBIT (1-tax rate) + (depreciation) + (amortization)
- (change in net working capital) - (capital expenditure)
- Earnings can often be adjusted by various accounting practices, but it's tougher to fake cash flow
- Buffett prefers FCF because of that
- If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run.
- You may see a Price/FCF (P/FCF) metric
Also from Investopedia:
- FCF analysis grew out of the desire to show how much cash flow exists beyond what is necessary to keep a firm operating at its current rate
- Accountants soon discovered this could not be easily determined from a cursory view of the financial statements
- One way around this is to combine information from the income statement and the balance sheet to create cash flow from operating activities, or CFO. A common formula for CFO is expressed as:
CFO = Net Income + Depreciation + Amortization + Non-cash Income - Net Working Capital
- Net working capital is essentially current assets less current liabilities
- There are limits to this approach; see the link
- Example: For the fiscal year ended January 31, 2017, Macy's Inc. recorded capital expenditures and cash flow from operating activities of $912 million and $1.801 billion, respectively, so FCF is:
Macy’s FCF = $1.801 billion - $912 million = $889 million
The company has a large amount of FCF that it can use to pay dividends, expand its operations, and deleverage its balance sheet i.e. reduce debt
From Motley Fool:
- “You can’t pay your bills with net income”
- FCF is harder to manipulate than other numbers
- One of the weaknesses of the income statement is that it spreads out the cash spent on long-term investments over time. For example, if Microsoft buys $1 billion in computer equipment, the expense is spread out over 2-3 years on its income statement in the form of depreciation. However, Microsoft doesn’t get to spread out the actual cash payment for computer equipment over 2-3 years. It pays for computer equipment up front, and in cash.
- Stated simply, the income statement is designed to smooth out a business’s uses of cash over time. The cash flow statement, from which free cash flow is calculated, offers no such smoothing benefit. It’s all about the here and now.
FCF = Cash flow from operations - capital expenditures
Typically, because of the volatility in free cash flow, you’ll find that it’s best to observe free cash flow over a period of a few years rather than a single year or quarter.
Companies that are capital light, meaning they don't have to make long-term investments as part of their business, will have very steady free cash flow over time. Free cash flow for a capital-light business will usually approximate net income. Companies that do have to make big long-term investments — building factories or buying bulldozers, for example — will have more volatile free cash flows.
The maturity of a business will also affect free cash flow. Mature businesses generally produce more consistent free cash flow, because they aren’t making continuously large investments to grow.
Here’s “Price to Free Cash Flow” and “Price to Sales” for three bio-tech companies:
- P/FCF = 14.6
- P/S = 5.6
- P/FCF = 9.9 *
- P/S = 4.1 *
- hard to tell on Fastgraphs; about right, but earnings are fading ~50% from 2015 peak
- P/FCF = 44.2
- P/S = 4.5
|Earnings, Adjust Operating||TBD|
|Net Working Capital||CurrentAssets - CurrentLiabilities|
|Operating Cash Flow||The amount of cash generated by the company’s normal business operations.
Concentrates on cash inflows and outflows related to a company’s main business activities, such as selling and purchasing inventory, providing services and paying salaries.
|PEG Ratio||In general, P/E is higher for a company with a higher growth rate.
In theory, the stock market should make PEG=1 for all stocks.
P/E=20 and ExpectedGrowth=20% = 1.
The price/earnings to growth ratio (PEG ratio) is a stock’s price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. The PEG ratio is used to determine a stock’s value while taking the company's earnings growth into account, and is considered to provide a more complete picture than the P/E ratio.
The lower the PEG ratio, the more the stock may be undervalued given its earnings performance. Broad rule of thumb is that a PEG < 1 is desirable (arguably a better purchase value).
If you’re looking at two good stocks and A has (PE=22 and PEG=1.1), and B has (PE=30 and PEG=0.6), it looks like A is better because of its lower P/E (it’s undervalued), but B is better, and is “trading at a discount to its expected growth rate and investors purchasing it are paying less per unit of earnings growth.” (link)
PE_Ratio = PricePerShare / EarningsPerShare
PEG = PE_Ratio / EarningsGrowthRate
PEG nails down value stocks:
The rate at which a company will grow its earnings going forward is a huge factor in determining its intrinsic value.
P/E shows how much shares are worth compared to past earnings.
High P/E = growth stock, Low P/E = value stock.
PEG < 1 means ExpectedGrowth is higher than current P/E. PE=20 and Growth=40 means PEG = 0.5.
Have to be careful to understand how the expected growth rate is calculated.
May be interpreted differently for Growth companies vs Value companies.
The Motley Fool guys like this so much they call it the “Fool Ratio.”
|ROA, ROE, ROI||TBD. I want to look at the differences between ROA, ROE, and ROI, and see when each is best applied.|
- EPS - basic vs diluted
- Free cash flow
- Operating cash flow
- Adjusted (operating) earnings
- Normalized basic earnings
- Diluted earnings
- ROA v ROE v ROI — when is each appropriate?
- What website(s) can help me find good Buffettology candidates?
- What website(s) can help me compare a company like Ford to its competitors?
- How should you read a financial statement? In what order? Early red flags to look for?
- When you get a new idea, start with Fastgraphs
- Create a Buffettology worksheet (so I can work through the evaluation process)
Resources used in creating this page
- Warren Buffett and the Interpretation of Financial Statements
- The Buffettology Workbook
- The New Buffettology
- The Intelligent Investor (by Benjamin Graham)
- Charlie Munger: The Complete Investor
- The Neatest Little Guide to Stock Market Investing
- The Warren Buffett Way
- Lots of ratios and data for right now; analysts recommendations; links to news; insider transactions
- Good screener
- In general, a lot of data in a compact format
- Click “financial highlights” to see Reuters data
- Picker/screener shows stocks they think are undervalued (Price vs Fair Value)
- Has a good summary page for each stock (but it doesn’t print well)
- Financial data goes back 5-10 years
- Lots of “moat” references
- Motley Fool
- Buy/Sell recommendations
- CEO approval rating
- Reuters (via Finviz)
- Possibly the best ratio information
- Good information for the current year
- Inside Transaction Resources
Notes from “The Buffettology Workbook”
- Buffett separates companies into two types:
- Commodities — don’t buy
- Consumer Monopolies — buy these
- Low profit margins w/ low inventory turnover
- Low returns on shareholder equity (low ROE)
- Erratic profits
- No brand loyalty
- Multiple producers of the product(s)
- Profitability depends on management’s ability to use tangible assets (Intel, GM, Ford)
- Consumer Monopolies
- A type of “toll bridge” business; if you want the product/service you have to get it from this company
- Can you create a competing business even if you don’t care about losing money?
- Sells a product where quality and uniqueness are the most important buying factors
- Don’t forget that they can still have ups and downs
- Consumer Monopoly keys
- A brand name product or service
- Usually has a high ROE
- Usually conservatively financed (little debt, or debt can easily be paid off from earnings)
- Must be able to retain its earnings and not have to spend earnings on maintaining current operations
- Four types of consumer monopolies
- Products are used up quickly, must be replenished, brand name appeal, merchants must carry
- Communication businesses that provide a repetitive service that manufacturers must advertise through
- Provide repetitive services that are consistently needed
- Retail stores that have a quasi-monopoly (jewelry, furniture)
- Four flavors of bad news:
- Stock market correction or panic
- Industry recession
- Individual business calamity (VLKAY, current Facebook issues)
- Structural changes
- Note: In the following lines I refer to Steps 1-10, and the Buffett books refer to them as Calculations 1-10
- Step 1
- Look at a 10-year summary of EPS, it tells you a great deal
- Look for a consistent upward trend, not wildly fluctuating earnings
- Look for strong EPS history with a temporary setback in the last year (or so)
- Step 2
- Purpose: determine your initial rate of return
- How to think: Look at the company’s earnings as being your earnings
- If the company makes $5/share and you own 100 shares, think, “I made $500”
- If you pay $25/share for a stock and it earns $5/share (EPS), you’re getting an Initial Rate of Return of 20% (5/25*100)
- The price you pay determines your initial rate of return:
- 5/25=20%, but 5/50=10%
- Step 3
- Purpose: Determine the per-share growth rate
- Goal: Is management growing EPS over time?
- Look at the last 10 years of EPS. Separate it into (a) total 10 years, and (b) just the last five years. Are earnings growing? The last five years should be higher than the total ten years.
- Example: 12% over ten years, and 16.6% over the last five years
- Assuming things look good, ask questions like these:
- What were the business economics that helped this business be successful? Is the situation the same or different?
- Is the company buying up its own stock?
- Is it investing in other growing businesses?
- KEY: Assuming company had a bad year, can the problem be solved?
- Step 4
- Purpose: Calculate the value relative to treasury bonds
- Current treasury bond rates: Bloomberg, CNBC
- All investment opportunities compete with each other
- The safest investment is a U.S. Treasury Bond
- You gain a perspective by comparing a stock to the return of a treasury bond
- Solution: Divide the EPS by the current return on treasury bonds
- H&R Block’s EPS was 2.77 in 2000, t-bonds were paying 6%
- 2.77 / 6% => $46.16
- This means that if you bought Block at 46.16, you’d be getting the same rate of return as if you bought 46.16 worth of t-bonds
- “Block has a value relative to t-bonds of 46.16 per share”
- If Block is cheaper than 46.16 it may be worth buying (Buffett bought at $24/share)
- With EPS of 2.77/share and a cost of 24/share, Block’s initial rate of return is 11.5% (2.77/24)
- Note: Block grew EPS at 7.6% from 1990 to 2000, so you think, “11.5% initial rate of return plus 7.6% compounded yearly”
- Step 5
- Note: Steps 5 & 6 are different in the Workbook vs the small book
- Purpose: Use EPS Annual Growth Rate to project a stock’s future value
- A consumer monopoly has such consistent earnings that Buffett refers to them as an “equity/bond”
- The EPS is the EquityBond’s yield
- If ShareholderEquity is $10/share and NetEarnings are 2.50/share, the company is getting a return on its EquityBond of 25% (2.50/10.00) (ROE)
- ShareholderEquity = Assets - Liabilities
- Buffett doesn’t care what the company is earning next year, he cares what it will be earning in ten years
- Another example follows
- Note: Links to CAGR calculators:
- Ex: Project Gannett’s future EPS for 2000
- From 1980 to 1990 Gannett’s EPS grew at a compounded rate of 9.6%
- EPS was 1.18 in 1990, assuming a constant 9.6%, it should be 2.95 in 2000
- To calculate using CAGR, PV=1.18, N=10, I=9.6%
- Summary: In theory, Gannett will have an EPS of 2.95 in 2000
- Ex: Project the market price of Gannett’s stock in 2000
- P/E from 1980-1990 varied from 11.5 to 23; average is 17.5
- If EPS is 2.95 in 2000, its projected stock price is $51.62 (2.95*17.5)
- Ex: Project the CAGR for Gannett between 1990-2000
- In 1990 Gannett’s price was $14.80/share
- CAGR: PV=14.80, FV=51.62, N=10
- That yields a CAGR of 13.3%
- Summary: If you buy their stock at 14.80 you get a CAGR of 13.3% for ten years
- Actual result: Gannett traded for $53-70/share in 2000
- Notes about that process
- Buffett doesn’t carefully calculate a very specific future price for the stock
- He doesn’t say, “I think the stock is worth X and it’s currently trading for X/2” as Graham did
- He instead asks, “If I pay X for this stock, what CAGR can I reasonably expect to get in ten years?”
- Don’t forget Mr. Market’s involvement: In the long term, the market will value the company to reflect the increase in the company’s net worth
- Step 6
- In the small book this is mostly a discussion of why a high ROE is important
- Good discussion of Company A with ROE of 33% vs Company B with an ROE of 8%
- The stock market goes down when interest rates go up, and the market goes up when interest rates go down
- This is because stocks compete against t-bonds for your money
- Also has an effect on bank loans and the cost of bonds that a company might issue
- Excellent businesses that have a DCA and have a high ROE can still be a bargain buy even when it seems that their P/E is high
- In the small book this is mostly a discussion of why a high ROE is important
- Step 7
- Calculation #8
- Calculation #9
- Calculation #10
- Does the company have a consumer monopoly? Describe it.
- Do you understand how it works? (the product and/or the business)
- What is the chance the company/product will become obsolete in the next 10-20 years? Explain why it won’t be.
- Is the company a conglomerate? If so, is it made of commodities and monopolies? Dig in.
- What is the EPS history?
- Does it have a consistent ROE of 15% or greater?
- Is it conservatively financed?
- Is the company buying back its shares?
- Is it free to raise prices with inflation?
- Is the company’s stock price suffering from a market panic, a business recession, or an individual calamity that is curable?
- What is the initial rate of the investment and its expected annual growth rate? How does it compare to investing in treasury bonds?
- Initial rate of return: ____
- Growth rate: ____
- Rate of return on t-bonds: ____
- Do the EquityBond calculations
- Average annual growth rate for shareholder’s equity for the last ten years: ____
- Average percentage paid out as a dividend: ____
- Company’s shareholder equity per share in the current year: ____
- Company’s average annual P/E ratio: ____
- Project growth rate of shareholders’ equity over the next ten years: ____
- Projected future trading price of the company’s stock: ____
- Current trading price of the stock: ____
- Project an annual CAGR using the historical annual EPS growth rate
- EPS in 1990: ____
- EPS in 2000: ____
- Make the buy?
Buffettology investing resources
- Three ETFs that replicate Buffett’s strategy
- Buffettology stock screeners
Good Buffett quotes
- Never invest in a business you don’t understand
- Forget about the stock market (buy companies)
- Lethargy, bordering on sloth, should remain the cornerstone of an investment style
- Act as though you have a “lifetime decision card” with just twenty punches on it
- Don’t take yearly results seriously, focus on 4-5 year averages
- The price you pay ultimately determines your annual compounding rate of return
- You don’t need to know someone’s exact weight to know he’s fat (Benjamin Graham)
I hope to add much more information related to a Buffettology style of investing on this page over time, but this is what I have for today.