- 1. Durability
- 2. The Income Statement
- 3. Balance Sheet
- A. Assets
- B. Liabilities
- i. Accounts Payable, Accrued Expenses, and Other Debts
- ii. Short-Term Debt
- iii. Long-Term Debt
- iv. Total Current Liabilities & The Current Ratio
- v. Deferred Income Tax, Minority Interest, & Other Liabilities
- vi. Total Liabilities & The Debt To Shareholders' Equity Ratio
- vii. Shareholders' Equity/Book Value
- viii. Return On Shareholders' Equity
- 4. The Cash Flow Statement
- 5. Valuing the Company with a Durable Competitive Advantage
Sell a unique product or service or be the low-cost buyer and seller of a product or service, and you get to cash in, year after years.
- Does it consistently have high gross margins?
- Does it consistently carry little or no debt?
- Does it consistently not have to spend large sums on research and development?
- Does it show consistent earnings?
- Does it show a consistent growth in earnings?
Durability of a competitive advantage is a lot like virginity-easier to protect than it is to get back.
Using income statement, to determine the company's margins, its return equity, and, most important, the consistency and direction of its earnings.
Using balance sheet to determine the amount of cash or the amount of long-term debt as indicators of the presence of a durable competitive advantage.
Using cash flow statement is good for seeing how much money the company is spending on capital improvements.
Gross Profit ÷ Total Revenues = Gross Profit Margin
- Gross profit margins >= 40% = some sort of durable competitive advantage.
- Gross profit margins < 40% = companies in highly competitive industries, where competition is hurting overall profit margins.
Any one of these three costs can destroy the long-term economics of the business.
- High research costs (e.g. Intel)
- High selling and administrative costs
- High interest costs on debt
- SG&A cost < 30% of Gross Profit = Fantastic
- SG&A cost 30% to 80% of Gross Profit = Many companies with a durable competitive advantage
- SG&A cost ~100% or > 100% of Gross Profit = Highly competitive industry with no sustainable competitive advantage
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, which means they are not a sure thing.
While using EBITDA, will miss out Depreciation/Amortization costs, use it with caution.
- Interest expense of less than 15% of operating income.
- Interest payments to operating income varies greatly from industry to industry.
In any given industry the company with the lowest ratio of interest payments to operating income is usually the company most likely to have the competitive advantage.
- Historical Net income >= 20% of Revenue => Good chance of some kind of long-term competitive advantage
- Historical Net income < 10% of Revenue => More likly not in a highly competitive business in which no one company holds a durable competitive advantage.
- Between 10% and 20% of revenue => which is just packed with businesses ripe for mining long-term investment gold that no one has yet discovered.
Exceptions is banks and financial companies, where an abnormally high ratio of net earnings to total revenues usually means a slacking-off in the risk management department. While the numbers look enticing, they actually indicate an acceptance of greater risk for easier money, which in the game of lending money is usually a recipe for making quick money at the cost of long-term disaster.
- High number for cash or cash equivalents tells
- A company has a competitive advantage that is generating tons of cash, which is a good thing,
- It has just sold a business or a ton of bonds, which may not be a good thing.
- Low amount or the lack of a stockpile of cash usually means that the company has poor or mediocre economics.
- With cash piling up company has to decide:
- Expand operations
- Buy entirely new businesses
- Invest in partially owned businesses via the stock market
- Buy back their shares
- Pay out a cash dividend to shareholders
- Ways of creating a large stockpile of cash:
- It can sell new bonds or equity to the public.
- It can also sell an existing business or other assets that the company owns.
- It has an ongoing business that generates more cash than the business burns.
- A simple test to see exactly what is creating all the cash is to look at the past seven years of balance sheets.
This will reveal whether the cash hoard was created by a one-time event (sale of new bonds or shares, or the sale of an asset or an existing business) or whether it was created by ongoing business operations. If we see lots of debt, we probably aren't dealing with an exceptional business. But if we see a ton of cash piling up and little or no debt, and no sales of new shares or assets, and we also note a history of consistent earnings, we're probably seeing an excellent business with the durable competitive advantage.
- For a manufacturing company, look for an inventory and net earnings that are on a corresponding rise.
This indicates that the company is finding profitable ways to increase sales, and that increase in sales has called for an increase in inventory, so the company can fulfill orders on time.
- Manufacturing companies with inventories that rapidly ramp up for a few years and then, just as rapidly, ramp down, are more likely companies caught in highly competitive industries subject to booms and busts.
Consistently lower percentage of Net Receivables to Gross Sales than its competitors, it usually has some kind of competitive advantage working in its favor that the others don't have.
- Prepaid expenses offer us little information about the nature of the business, or about whether it is benefiting from having a durable competitive advantage.
- The current ratio almost useless in helping us identify whether or not a company has a durable competitive advantage.
A company able to finance any new plants and equipment internally, instead of debt.
- Increase in goodwill of a company over a number of years, we can assume that it is because the company is out buying other businesses. Good thing if the company is buying businesses that also have a durable competitive advantage.
- If the goodwill account stays the same year after year, that is because either the company is paying under book value for a business or the company isn't making any acquisitions.
- Patents, copyrights, trademarks, franchises, brand names, and the like
- The durable competitive advantage's power to increase shareholders' wealth has remained hidden from investors for so long. e.g. Coke’s brand name is worth of $100 billion
- A company's long-term investments can tell us a lot about the investment mind-set of top management.
- Do they invest in other businesses that have durable competitive advantages, or do they invest in businesses that are in highly competitive markets?
- High returns on assets may indicate vulnerability in the durability of the company's competitive advantage. e.g. Moody has very high ROA, but raising $1.7 billion to take on Moody’s is within the realm of possibility, than raising $43 billion to take on Coca-Cola
- Tell us a lot about the current situation of a business, but as stand-alone entries they tell us little about the long-term economic nature of the business and whether or not it has a durable competitive advantage.
We borrow short-term money at 5% and lend it long-term for 7% sounds easy enough. But the problem with this strategy is that the money we borrowed is short-term money. That means that we have to pay it back within the year, which is easy enough to do, we just borrow more money short-term to pay back the short-term debt that is coming due. In the financial world, this is called "rolling over the debt.” If we lend all this money long-term, but our creditors decide not to loan us any more money short-term. Suddenly we have to pay back all that money we borrowed short-term and lent long-term. But we don't have it, because we lent it long-term, which means that we won't get paid back for many, many years.
- In financial institutions stay away from companies that are bigger borrowers of short-term money than of long-term money.
- Aggressive borrowers of short-term money are often at the mercy of sudden shifts in the credit markets, which puts their entire operation at risk and equates with a loss of any kind of durability in their business model.
- If there have been ten years of operations with little or no long-term debt on the company's balance sheet it is a good bet that the company has some kind of strong competitive advantage working in its favor.
- If all else indicates that the business in question is a company with a durable competitive advantage, but it has a ton of debt on its balance sheet, a leveraged buyout may have created the debt. In cases like these the company's bonds are often the better bet, in that the company's earning power will be focused on paying off the debt and not growing the company.
- Too much debt coming due in a single year can spook investors, which will give us a lower price to buy in at.
- With a mediocre company that is experiencing serious problems, too much debt coming due in a current year can lead to cash flow problems and certain bankruptcy, which is also certain death to our investment.
- Companies with a durable competitive advantage often have current ratios under one. Immense earning power causes this anomaly is.
- The Current Ratio is of little use in telling us whether or not a company has a durable competitive advantage.
- All these entries tells us little about durable competitive advantage.
- When the company acquires the stock of another, it books the price it paid for the stock as an asset under "long-term investments". But when it acquires more than 80% of the stock of a company, it can shift the acquired company’s entire balance sheet onto its balance sheet. The same with the income statement.
If company A acquires 80% stocks of company B, then company A can show acquired company’s entire balance sheet onto its balance sheet, and also adds 20% minority interest.
- The company with a durable competitive advantage will be using its earning power to finance its operations and therefore, in theory, should show a higher level of shareholders' equity and a lower level of total liabilities.
- The company without a competitive advantage will be using debt to finance its operations and, therefore, should show just the opposite, a lower level of shareholders' equity and a higher level of total liabilities.
- Companies with a durable competitive advantage don't need a large amount of equity/retained earnings. Because of their great earning power they will often spend their built-up equity/retained earnings on buying back their stock, which decreases their equity/retained earnings base. That in turn increases their debt to equity ratio, often to the point that their debt to equity ratio looks like that of a mediocre business, one without a durable competitive advantage.
- With financial institutions like banks, the D/E ratio, on average, tend to be much higher than those of their manufacturing cousins.
- D/E < 0.80 there is a good chance that the company in question has the durable competitive advantage.
- The amount of money that the company's owners/shareholders have initially put in and have left in the business to keep it running.
- A durable competitive advantage company, tend not to have preferred stock.
- The dividends paid on preferred stock are not deductible, which tends to make issuing preferred shares very expensive money.
- A dramatic increase in the number of shares outstanding over a number of years without an increase in the company's earnings usually means that the company is selling new shares to increase its capital base to make up for the fact that it is a mediocre business
- It is important in that if a company is not making additions to its retained earnings, it is not growing its net worth. If it not growing its net worth, it is unlikely to make any of us superrich over the long run.
Microsoft shows a negative number because it decided that its economic engine is so powerful that it doesn't need to retain the massive amount of capital it has collected over the years and has instead chosen to spend its accumulated retained earnings and more on stock buybacks and dividend payments to its shareholders.
- Stocks bought back are added in Treasury Stock, with the possibility of reissuing them later on.
- A company with a durable competitive advantage is the presence of treasury shares on the balance sheet.
The presence of treasury shares on the balance sheet, and a history of buying back shares, are good indicators that the company has a durable competitive advantage.
- High returns on equity mean that the company is making good use of the earnings that it is retaining.
- Some companies are so profitable that they don't need to retain any earnings, so they pay them all out to the shareholders. In these cases we will sometimes see a negative number for shareholders' equity.
If the company shows a long history of strong net earnings, but shows a negative shareholders' equity, it is probably a company with a durable competitive advantage.
- If capital expenditures remain high over a number of years, they can start to have deep impact on earnings.
- Sum total capital expenditures for a ten years and compare with total net earnings for the same ten years. Capex should be small % of net earnings.
- Capex < 50% of net earnings is good place to look for a durable competitive advantage
- Capex < 25% of net earnings company has a durable competitive advantage
Wrigley annually uses approximately 49% of its net earnings for capital expenditures. Altria uses approximately 20%; Procter & Gamble, 28%; Pepsico, 36%; American Express, 23%; Coca-Cola, 19%; and Moody’s, 5%
- The per-share earnings continue to rise over time-either through
- increased business
- expansion of operations
- the purchase of new businesses
- the repurchase of shares with money that accumulates in the company's coffers.
- For companies with competitive advantage, market over time, will price the company's shares at a level that reflects the value of its earnings relative to the yield on long-term corporate bonds.
- In bear markets for starters. Though they might still seem high priced compared with other "bear market bargains,” in the long run they are actually the better deal.
- At the height of bull markets, when these super businesses trade at historically high price-to-earnings ratios.
- When you need money to make an investment in an even better company at a better price, which occasionally happens.
- When the company looks like it is going to lose its durable competitive advantage.
A simple rule is that when we see P/E ratios of 40 or more on these super companies, and it does occasionally happen, it just might be time to sell. But if we do sell into a raging bull market, then we shouldn't go out and buy something else trading at 40 times earnings. Instead, we should take a break, put our money into U.S. Treasuries and wait for the next bear market. Because there is always another bear market right around the corner, just waiting to give us the golden opportunity to buy into one or more of these amazing durable competitive advantage businesses that will, over the long-term, make us super superrich.