In 2011 Mary Buffett and David Clark released a book that outlines Warren Buffett’s approach to investing (Warren Buffet and the Interpretation of Financial Statements). I found this such an excellent encapsulation of what I had pieced together from various sources over the years that I knocked up a financials template based upon it so I could systematically analyse a company’s numbers.
The image below outlines the template, using Coca-Cola to demonstrate a competitive advantage company with impeccable financials in almost every way (except the price!).
The template works through first the income statement, then the balance sheet and then the income statement (from which we can value the company as an ‘equity bond’). Some of the financials are more salient than others, but what is important is that an investor considers all aspects of the accounts over time in order that flags can be investigated and pondered upon.
Competitive advantage companies (CAC’s) will usually have a profit margin (1) of 50+% and ideally a net earnings margin (7) of c.20%, although an operating margin this high (like Coca-Cola’s) is quite rare. This demonstrates that the company has a ‘moat’ to insulate it against eroding its margins in response to competition.
The sum total of selling, general and administrative expenses plus R&D expenses (2) should be less than 60% of revenues and annual depreciation costs (3) should be less than 10%. This demonstrates that the company does not have to spend excessively in order to maintain its position.
Interest expenses (4) should be less than 15% of revenues (unless it is a bank of course), for reasons obvious to anyone who has a credit card, and should ideally be amongst the lowest in the respective industry. It is worthwhile checking that income taxes (6) are a relatively stable percentage of net earnings in order to flag any shenanigans the company might be playing with its tax bill.
Finally, net earnings (7) should ideally demonstrate a smooth upward trajectory over time.
A CAC should have an abundance of cash (8) from its operations (not asset sales) and this should ideally smoothly increase over time. Inventory (9) should ideally increase smoothly over time to indicate increasing sales, unless of course it is primarily a services company.
Goodwill (11) is how the price paid for a company over book value is accounted for on the balance sheet. If this reduces it is a flag that the performance of acquisitions is deteriorating against previous expectations.
Return on assets (15) (i.e. net earnings / revenues) should be high and ideally the assets should be non-replicable by competitors, either through their value or their uniqueness.
CAC companies should not require a burdensome debt load and long-term debt (16) should be payable with less than 3 to 4 years of operating earnings. There should also be not be a burdensome amount of debt coming due in-year (17) and short-term debt (18) should be significantly less than long-term debt. Total liabilities should be less than 80% of total equity + treasury stock (22).
Retained earnings (25) should increase consistently over time. Many CAC’s buy back their own stock to put the cash they throw off to good use and indirectly return cash to the shareholder. Therefore an increase in treasury stock (26) (where shares are held if not cancelled) is a good sign. However, the investor should always analyse at what valuation shares are being bought bought back. If the stock is overpriced this is not good capital allocation.
Finally, return on equity (27) (net earnings / shareholders equity) should ideally be 20+%.
Cash Flow Statement
The cash flow statement is where the company is valued as an ‘equity bond’ bases upon ‘owner earnings’. Warren Buffett detailed his valuation method based upon owner earnings in his an appendix to his 1986 shareholders letter. He defines owner earnings as (a) reported earnings, plus (b) depreciation, depletion, amortisation and other non-cash charges such as inter-period adjustments, minus (c) the average amount of capex expenditure required to fully maintain a company’s long-term competitive advantage advantage and unit volume.
This is essentially how much money is left ‘in the till’ for the company owner at the end of each year. If a company has a competitive advantage the investor can assume a company will maintain these earnings over the long-term. Therefore if this cash flow over time is discounted to its net present value it provides an ‘intrinsic value’ for the company. No future growth in owner earnings is assumed, that is just a bonus.
How this cash flow is discounted is up to the individual investor and their view of future inflation rates that erode the purchasing power value of future cash flows. The Hinterland takes owners earnings and multiples them by 12.3. This indicates the net present value of the next 15 years of owner earnings assuming an average of approx. 3% inflation over time.
If a CAC is selling at this intrinsic value figure it would be a relatively safe investment over the long-term. If it is selling at a discount to intrinsic value this is the ‘margin of safety’ that Ben Graham talks about. Ideally, one would prefer a 30% margin of safety, but this would be a rarity for a CAC. Owner earnings / market capitalisation can also be expressed as percentage. 8% is a fair return for a CAC, 12% provides a 30% margin of safety.
Looking at Coca-cola below, we see that its financials are excellent in every way except its price (30). Net earnings ($9.806bn) + depreciation ($1.982bn) – capex ($2.780bn) equals owner earnings of $8.288bn.
If this $8.288bn multiplied by 12.3 it indicates an intrinsic value of £101.942bn (31). This is 42% lower than the current market cap of $174.917bn (30).
If this $8.288bn is divided by Coca-cola’s market cap of $174.917bn, it indicates that Coca-cola’s yield as an ‘equity bond’ is 4.74%.
This may be an acceptable return to an ultra conservative investor, but it is not much above inflation. The Hinterland recently sold Coca-cola and would only be looking to buy back in at a yield of at least 8%. It’ll be a long wait.
The author holds no position in KO.