interpretation of financial statements by Benjamin Graham

• Published in 1937, Ben Graham covers the basics of accounting and financial statements. It’s a condensed guide on reading the balance sheet and income statement, explaining standard metrics, and providing tips on determining a company’s soundness.

• Financial statements show a company’s financial soundness and operating results.

• The balance sheet shows how much a company owns (assets) and owes (liabilities) at a particular time. Assets and liabilities must balance out.

  • Assets = property like plants and equipment, accounts receivable, cash, intangible assets like goodwill, etc.
  • Liabilities = accounts payable, current debt, long-term debt plus stockholder equity, etc.
  • Intangible assets can be over-inflated or deflated depending on the company. The same is true for goodwill and assets written down through depreciation.

• A company’s size can be measured by its assets or sales relative to the other companies in the industry.

• On small-cap investing: “Where the purchase is made for speculative profits or long-term capital gains, it is not essential to insist upon the dominant size, for there are countless examples of smaller companies prospering more than larger ones. After all, the large companies themselves presented the best speculative opportunities while there were still comparatively small.”

• The term “watered stock” was given to companies that inflated their asset value, thus inflating book value, which was later written off with special charges against earnings. Graham offers U.S. Steel’s inflated $600 million worth of assets. In other words, asset values on a balance sheet may or may not represent an accurate value of an asset.

• Depreciation, amortization, and depletion apply a normal wearing out or aging of building and equipment over its typical lifespan. It allows the asset’s cost to be charged off (the income statement) over several years.

• Depletion is used in commodity businesses like mining or oil to account for resources taken out of the ground.

• Current assets listed as “marketable securities” might be a place to unearth hidden value.

Intangible assets can’t be accurately weighed or measured. Includes patents, trademarks, goodwill, etc.

• There might be hidden value found in goodwill. If goodwill is written off after a company has improved financially, it’s likely that goodwill is worth more than what is stated on the books.

• The real value of intangible assets is more likely found in the income statement than the balance sheet. “The earning power of these intangibles rather than their balance sheet valuation counts.”

• Current assets are cash or assets that are easily converted into cash like receivables and inventory — and are shown in order of liquidity.

• Current liabilities are debts incurred during normal business operations to be paid or maturing within one year.

• Current Ratio = current assets/current liabilities. A high current ratio shows that the company will have no problem meeting short-term obligations.

• More liquid current assets allow for a lower margin above current liabilities.

• Working Capital (or Net Current Assets) = current assets – current liabilities.

• An excess of Working Capital makes it easier for a company to run daily operations, grow the business, and meet emergency needs without taking on new financing. A lack of working capital means its harder to cover current liabilities and likely means forgoing business growth, with a worst-case scenario of bankruptcy.

• Graham’s Net-Net Working Capital Strategy: “The working capital available for each share of common stock is an interesting figure in common stock analysis. Over the years, the growth or decline of the working capital position is also worthy of the investor’s attention.”

• Quick Ratio = (Current Assets – Inventory)/Current Liabilities

• Inventory should be looked at concerning other factors to assess how efficiently the company turns assets into profit — like turnover (turnover ratio = annual sales/inventory). Inventory turnover can be compared on a year-to-year basis.

• Receivables can be looked at against sales and compared year to year. A large ratio of receivables to sales means the company may be at a higher risk of loss due to unpaid accounts. Also, watch for companies that allow long-term payment options.

• Stocks selling below their cash value per share may be worth more than their value by the market. Stockholders may benefit from an appreciation in price or distribution of cash.

• “The most important individual item among the current liabilities is that of Notes Payable.” If notes payable — accounts payable — are larger than cash and receivables, the company may be too reliant on credit. Over several years, if accounts payable grows faster than sales and profits, it’s a sign of weakness.

• Reserve is an all-encompassing term for money to be used for a specific purpose.

• Graham breaks reserves into three classes:

  • Definite liabilities — for taxes, accident claims, legal settlements, customer refunds, etc., that are closer to current liabilities
  • Offset against an asset — losses on receivables, decline in inventory may be an actual decline or set up to offset a future decline (if it’s a future decline, it may be a surplus).
  • a surplus — contingency reserves or money set aside for a future purpose that is more likely not used as intended but only if it gets transferred back to surplus.

• Book value attempts to show the liquidation value of all the tangible assets, but the true liquidation value is more likely to be less than book value. The reason: inventory and fixed assets are likely to be sold at a significant loss.

• Book Value = total assets – intangible assets – liabilities.

• Book value may be overstated or understated depending on reserves that should be considered a surplus. Reserves considered a surplus should be added to book value to get a closer approximation of the true book value.

• Net Current Asset Value (NCAV) = Current assets – liabilities and preferred stock. NCAV might be a good representation of liquidation value if current assets are a large portion of total assets. Stocks selling below NCAV may be extremely undervalued.

• Earning Power = a company’s expected earnings over future years.

• Maintenance and depreciation may under or overstate earnings.

• Average earnings over several years should easily cover interest and dividend payments.

• Be aware of companies showing a trend in improved earnings. “However, before purchasing a common stock because of its favourable trend, it is well to ask two questions: (a) How certain am I that this favourable trend will continue, and (b) How large a price am I paying in advance for the expected continuance of the trend?”

• Future earnings estimates explain why two stocks with similar earnings per share can trade at vastly different P/E ratios. A low P/E stock has a low expected earnings growth priced in, while a high P/E stock reflects a high expected earnings growth.

Warren Buffett and the interpretation of financial statements

• 3 ways that corporations can use financial reporting to enhance their value are:
  • reduce their cost of capital
  • improve their credit ratings
  • increase their price-earnings multiple
• “every debit must have a credit,” double entry system.
• a well-managed and profitable business will show a strong cash flow through the plumbing of accounts from net income to growing/decreasing equity and/or dividend.
• cash-based accounting:
  • Transactions are recorded based on the inflow and outflow of cash when the money changes accounts, not when the service or product is provided or received.
  • useful for small businesses that operate on a cash basis, such as “mom and pop” style businesses.
  • it’s not a good fit for large businesses because it is slow and delayed in tracking revenues and expenses.
• accrual accounting:
  • expenditures must be recorded when incurred and not when paid. Similarly, revenue must be recorded when there is an outflow of services or goods.
  • it provides a more precise and realistic picture of the company’s performance. However, cash flow statement analysis would be required to account for any inconsistencies caused by accrual accounting.
• companies with net incomes consistently at or more than 20% of revenues often are industry leaders
• companies with strong liquidity and little external debt are likely to “sail on through the troubled times.”
• Buffett sees stocks as “equity bonds” with ever-rising “yields,” or earnings per share.
• consider selling any stock priced more than 40 times its earnings per share.
• avoid investing in companies with high expenses for research, depreciation and interest.
• Warrent Buffet interpretation of financial statements
• interpretation of financial statement by benjamin graham
• Warren Buffet and the analysis of financial statements
• Warren Buffett and the interpretation of financial statements

The Divergent Styles of Warren Buffett and His Mentor

• In the 1950s, an economist and professional investor named Benjamin Graham served as a mentor to Warren Buffett, who became one of the world’s wealthiest people. Graham pioneered the practice of value investing – buying into companies with low stock prices. Buffett, Graham’s student at New York’s Columbia University, later worked as an analyst at Graham’s Wall Street investment firm.
• When he started his own investment business, Buffett altered the Graham value investing method in several ways. Buffett ignores the Graham rule of selling stocks after they appreciate by 50% because sometimes their prices will rise much more. Graham would buy a stock based primarily on its cost – the lower, the better. Buffett favours high-quality companies with predictable cash flows, so he is inclined to pay a “fair price” for their shares, not necessarily the lowest amount possible. Graham espoused the importance of holding a diversified portfolio of stocks, increasing the odds that moneymaking stocks would offset losers. Buffett prefers a portfolio concentrated on a few stocks that he considers excellent investments.
• Buffett studies the financial statements of companies to distinguish the best from the rest. He believes that top firms share certain financial characteristics. He invests only in financially self-sustaining companies with such a strong “durable competitive advantage” over their rivals that it creates “monopoly-like economics, allowing them either to charge more or to sell more.”

Three Business Models That Buffett Likes Best

• The companies that attract Buffett’s investment operate one of three business models: “They sell either a unique product or a unique service, or they are the low-cost buyer and seller of a product or service the public consistently needs.” Firms that sell unique products include, for instance, beer brewer Budweiser, soft drink producer Coca-Cola and candy maker Hershey. Many other companies sell beer, soda and chocolate, but they lack the singular brand power of Bud, Coke and Hershey’s. Examples of companies that sell uniquely branded services include credit rating agency Moody’s Corp., tax service provider H&R Block, Inc. and bank Wells Fargo & Co. Retail chains Walmart and Costco, and the Burlington Northern Santa Fe Railway, fit into the third type of business model: the lowest-cost provider of such staples as food and clothing or such fundamental services as transportation. Buffett favours these well-known companies with powerful brands that command “a piece of the consumer’s mind.”

Hunting for Value in Financial Statements

• Warren Buffett reads three types of financial statements to learn about a business: its income statement, balance sheet and cash flow statement. He analyzes these statements individually and collectively to discern the truth about a company’s prospects and the value of its stock.
• The income statement, issued quarterly and annually, summarizes revenue, operating costs, overhead expenses and net results, which are either profits or losses. The cash flow statement accounts for cash provided or consumed by operations, investments and financing activities over some time. In contrast, the balance sheet captures the condition of a firm at one point; it summarizes the state of assets and liabilities on a particular date. Buffett compares different line items on financial statements to assess the strengths and weaknesses of companies. For example, he subtracts the cost of goods sold (materials and labour) from revenue to determine gross profit and then divides gross profit by revenue to calculate the company’s gross profit margin. A firm that reliably achieves margins of 40% or more probably has a durable competitive advantage.
• Companies operating activities generate selling, general and administrative (SGA) expenses, such as executive compensation, advertising fees and legal costs. Like many line items in financial statements, SGA expenses convey limited information about an organization and its likely fate. Comparisons of line items are more instructive. For example, Buffett checks the percentage of gross profit these expenses devour. Companies with stable SGA expenses as a gross profit percentage tend to have dominant positions in their industries. In general, “anything under 30% is considered fantastic.”

The Burden of Research, Depreciation and Interest Expenses

• Buffett avoids investing in businesses burdened by huge commitments to research and development, preferring companies like Coca-Cola, an industry leader selling the same secret-formula beverage for more than 100 years. In some industries, such as information technology, research and development is a critical sources of competitive clout. But technological change is so fast that any competitive advantage from a research breakthrough could prove fleeting. Consider the relative R&D burdens of chewing gum maker Wrigley and automaker General Motors: GM constantly must invest in R&D to design new vehicles or risk losing market share. Wrigley has been selling the same famous chewing gum brand for decades. Which company has been a better investment? By 2008, an investor who bought $100,000 of stock in each company in 1990 would have GM shares worth $97,000 and Wrigley shares worth $547,000. Buffett is not fond of heavy depreciation and interest expenses, either. Depreciation reflects the non-cash cost of wear and tear on operating assets, such as buildings and equipment. Buffett likes to invest in companies with low depreciation expenses as a percentage of gross profits. Similarly, he routinely seeks businesses with annual interest payments that consume the smallest possible fraction of gross profit – the less interest expense, the less debt the firm carries.

Rating Companies by Their Returns on Revenue

• Profitable companies divide their net income by the number of outstanding common shares to determine earnings per share, a financial metric that securities analysts widely use. However, Buffett pays more attention to the net income in his appraisal of companies. He divides net income by revenue to calculate a firm’s return on revenue and, in turn, assess its competitive position. If its return on revenue is consistently greater than 20%, the company probably has a pivotal, ongoing advantage over the rest of its industry. If its return on revenue is steadily below 10%, the firm likely operates in an intensely competitive field. Many companies have returned from 10% to 20%, and some of them represent “long-term investment gold that no one has yet discovered.”

The Asset Side of the Balance Sheet

• The balance sheet shows a firm’s assets, liabilities and shareholders’ equity at a certain date. Total assets minus total liabilities equals equity. These three balance sheet components convey essential information about a firm’s future. Current assets include cash and liquid investments as well as inventory and accounts receivable that the firm can convert to cash within a year. These “working assets” and their amounts vary depending on the company’s day-to-day operations. For instance, cash relative to accounts receivable may fluctuate as business conditions change. Non-current assets include property, plant and equipment, and such intangibles as franchises, copyrights and patents.

• Buffett likes to see a strong cash and liquid investments position paired with little external debt. Businesses with this profile are rather likely to “sail on through the troubled times.” Buffett also calculates the net amount of accounts receivable, or receivables minus bad debts, as a percentage of sales revenue; companies with a low percentage often are leaders in their industries.

The Liability Side of the Balance Sheet

• Current liabilities are debts due within one year. These include accrued expenses, accounts payable and short-term loans. Other classes of liabilities include long-term debt maturing in more than one year. Generally, companies with an enduring edge over their rivals are generating enough cash internally to preclude the need to accumulate large amounts of long-term debt.
• The ratio of current assets to current liabilities, or the “current ratio,” is a common measure of corporate liquidity. In conventional analysis, a current ratio of more than one indicates better liquidity than a ratio of less than one. But, according to Buffett, certain companies with a commanding advantage have current ratios below one because their reliably solid businesses negate the need for a big “liquidity cushion” against insolvency. Buffett applies the same argument to the ratio of long-term debt to shareholders’ equity: Some companies that lead their industries to have higher debt-to-equity ratios because they use a big portion of their net income to repurchase stock or pay dividends. These two uses of earnings affect the growth of shareholders’ equity, but neither indicates that a company is facing fierce competitive pressure.

The Magic of Retained Earnings

• Retained earnings represent net income that a company reinvests in its operations instead of spending it on stock repurchases or dividend payments. Retained earnings are a component of shareholders’ equity on the balance sheet; amassing retained earnings increases shareholders’ equity, or the firm’s net worth. Buffett believes companies with rapidly growing retained earnings will likely have a long-term advantage over their competitors.
• Buffett runs a publicly traded investment holding company called Berkshire Hathaway that does not pay dividends to its shareholders. This policy has helped Berkshire accumulate a mountain of retained earnings, contributing to a significant, long-term increase in the firm’s value: Its pretax earnings per share rose from $4 in 1965 to $13,023 in 2007. Buffett prefers stock repurchases to dividend payments as a means of rewarding shareholders. By buying back its shares, a company can increase its earnings per share without actually earning more net income; as earnings per share increase, the price of the shares is likely to increase, too.
• Tax liability is a major consideration. Buffett would have to pay income tax if he received dividends on his Berkshire stock. Instead, he will accumulate capital gains on his Berkshire stock tax-free as long as he holds the stock. He has already stockpiled $64 billion of unrealized capital gains on his Berkshire shares and has not yet paid any tax on these paper profits.

Buying, Holding and Selling “Equity Bonds”

• Because Berkshire Hathaway makes long-term investments in companies with substantial, sustainable competitive advantages, it owns stocks that behave like bonds with yields that rise over time. Buffett calls these stocks “equity bonds.” Instead of a regular bond’s cash interest payments, the yield on an equity bond is the company’s earnings per share. And as earnings per share growth over time, so does yield on an equity bond. For instance, during the late 1980s, Buffett bought stock in Coca-Cola at prices averaging $6.50 per share at a time when the company had annual earnings of 46 cents per share, “which in Warren’s world equates to an initial rate of return of 7%. By 2007, Coca-Cola was earning $2.57 a share,” translating to a 39.9% return on his original investment.

• Buffett is a long-term investor in the stocks of companies with durable competitive advantages because “the longer you hold on to them, the better you do.” Nevertheless, three types of circumstances make selling a great stock advisable: if proceeds from the sale could fund a better investment, if the company is ceding its competitive advantage or if the price of the firm’s shares soars in an overheated bull market. If a company’s stock price is 40 times more than its annual earnings per share, “it just might be time to sell.”

• However, rather than buy another stock trading at 40 times earnings, Buffett prefers to hold on to his cash until the market settles down and great equity bonds once again become available at affordable prices.

• Clearly, the Buffett investing style requires patience, but the potential payoff is enormous.

D.C.A. and income statement summary

• gross profit margin
  • Firms with excellent long-term economics tend to have consistently higher margins
  • Durable competitive advantage creates a high margin because of the freedom to price over the cost
    • Greater than 40% = Durable competitive advantage
    • Less than 40% = competition eroding margins
    • Less than 20% = no sustainable competitive advantage
  • Consistency is key
• Sales Goods and Administration
  • Companies with no durable competitive advantage show wild variation in SG&A as % of gross profit
    • Less than 30% is fantastic
    • Nearing 100% is in the highly competitive industry
  • Consistency is key
• R&D
  • If a competitive advantage is created by a patent or tech advantage, it will disappear at some point.
  • High R&D usually dictates high SG&A which threatens the competitive advantage
• depreciation
  • Companies with durable competitive advantages tend to have lower depreciation costs as a % of gross profit
• interest expenses
  • Companies with high-interest expenses relative to operating income tend to be either:
    • in a fiercely competitive industry where large capital expenditure is required to stay competitive
    • a company with excellent business economics that acquired debt in the leveraged buyout
      • Companies with durable competitive advantages often carry little or no interest expense.
      • Warren’s favourites in the consumer products category all have less than 15% operating income.
      • Interest expenses vary widely between industries.
      • Interest ratios can be very informative of the level of economic danger.
  • In any industry, the company with the lowest interest ratio to Operating Income usually has a competitive advantage.
• net earnings
  • Look for consistency and upward long-term trend.
  • Because of share repurchase, it is possible for the net earnings trend to differ from the EPS trend.
  • Preferred over EPS
  • Durable competitive advantage companies report higher % net earnings to total revenues.
  • If net earnings are less than 10%, likely to be in a highly competitive business
  • If a company shows net earnings history greater than 20% of total revenues, it is probably benefiting from a long-term competitive advantage.
• EPS
  • 10-year period showing consistency and an upward trend.
    • it may be an indicator that products don’t need to change.

D.C.A. and balance sheet summary

• cash and equivalents

  • A high number means either:
    • 1. The company has a competitive advantage generating lots of cash
    • 2. Just sold a business or bonds (not necessarily good)
  • A low stockpile of cash usually means poor to mediocre economics.
  • There are three ways to create a large cash reserve.
    • 1. Sell new bonds or equity to public
    • 2. Sell business or asset
    • 3. It has an ongoing business generating more cash than it burns (usually means durable competitive advantage)
  • When a company is suffering a short-term problem, Buffett looks at cash + marketable securities + little debt to see whether it has the financial strength to ride it out.
  • Test to see what is creating cash by looking at the past 7 yrs of balance sheets. This will reveal how the cash was created.

• inventory

  • Manufacturers with durable competitive advantages have the advantage that the products they sell do not change and, therefore, will never become obsolete. Buffett likes this advantage.
  • When identifying manufacturers with a durable competitive advantage, look for inventory and net earnings that rise correspondingly. This indicates that the company is finding profitable ways to increase sales which calls for an increase in inventory.
  • Manufacturers with inventories that spike up and down indicate competitive industries subject to boom and bust.

• Net Receivables

  • Net receivables tell us a great deal about competitors in the same industry. In competitive industries, some attempt to gain an advantage by offering better credit terms, causing an increase in sales and receivables.
  • If the company consistently shows a lower % Net receivables to gross sales than competitors, then it usually has some competitive advantage which requires further digging

• Property, Plant & Equipment

  • A company with a durable competitive advantage doesn’t need to upgrade its equipment to stay competitive constantly. The company replaces it when it wears out. On the other hand, a company without any advantages must replace to keep pace.
  • Difference between a company with a moat and one without is that the company with the competitive advantage finances new equipment through internal cash flows. In contrast, the no-advantage company requires debt to finance.
  • Producing a consistent product that doesn’t change equates to consistent profits. There is no need to upgrade plants which frees up cash for other ventures. Think Coca-Cola, Johnson & Johnson etc.

• goodwill

  • Whenever you see an increase in goodwill over many years, you can assume it’s because the company is out buying other businesses above book value. GOOD if buying businesses with a durable competitive advantage.
  • If goodwill stays the same, the company, when acquiring other companies, is either paying less than book value or not acquiring. Businesses with moats never sell for less than book value.

• Intangible Assets

  • Intangibles acquired are on the balance sheet at fair value.
  • Internally developed brand names (Coke, Wrigleys, Band-Aid) are not reflected on the balance sheet.
  • One of the reasons competitive advantage power can remain hidden for so long

• Total Assets & Return on Total Assets

  • Measure efficiency using ROA
  • Capital is a barrier to entry. One thing that makes a competitive advantage durable is the cost of assets needed to get in. This is why we calculate the Asset Reproduction Value along with the EPV.
  • Many analysts argue the higher return, the better. Buffett states that high ROA may indicate vulnerability in the durability of the competitive advantage.

  For example- E.g. Raising $43b to take on KO is impossible, but $1.7b to take on Moody’s is. Although Moody’s ROA and underlying economics are far superior to Coca Cola, the durability is far weaker because of lower entry cost.

• Current Liabilities

  • Includes accounts payable, accrued expenses, other current liabilities and short-term debt.
  • Stay away from companies that ‘roll over the debt,’ e.g. Bear Stearns
  • When investing in financial institutions, Buffett shies from bigger borrowers of short-term than long-term debt.
    • His favourite ‘Wells Fargo’ has 57 cents of short-term debt for every dollar of long term
    • Aggressive banks (like Bank of America) have $2.09 short-term for every dollar long term
  • Durability equates to the stability of being conservative.

• Long-Term Debt coming Due

  • Some companies lump their yearly long-term debt due with short-term debt on the balance sheet. This makes it seem like there is more short-term debt than the real amount.

  • Important: Companies with durable comparable advantages need little or no LT debt to maintain operations.

  • Too much debt coming due in a single year spooks investors and can offer attractive entry points.

  • However, a mediocre company with problems with too much debt due leads to cash flow problems and certain bankruptcy.

• long-term debt

  • Buffett says that durable competitive advantages carry little to no LT debt because the company is so profitable that even expansions or acquisitions are self-financed.

  • We are interested in long-term debt load for the last ten years. If the ten yrs of operation show little to no long-term debt, the company has some strong competitive advantage.

  • Buffett’s historic purchases indicate that on any given year, the company should have sufficient yearly net earnings to pay all long-term within a three or 4-year earnings period. (e.g. Coke + Moody’s = 1yr)

  • Companies with enough earning power to pay the long-term debt in less than 3 or 4 years are good candidates in our search for long-term competitive advantage.

  • But, these companies are targets for leveraged buyouts, which saddles the business with long-term debt

  • If all else indicates the company has a moat, but it has a ton of debt, a leveraged buyout may have created the debt. In these cases, the company’s bonds offer the better bet in that the company’s earnings power is focused on paying off the debt and not growth.

  • Important: little or no long-term debt often means a Good Long Term Bet

• Total Liabilities & Debt to Shareholders Equity Ratio

  • Debt to shareholders equity ratio helps identify whether the company uses debt or equity (includes retained earnings) to finance operations.
  • A company with a moat uses earning power and should show higher equity and lower liabilities.
  • Debt to Shareholders Equity Ratio: Total Liabilities / Shareholders Equity
  • Problem with using it as the identifier is that the economics of companies with durable competitive advantages are so great they don’t need a large amount of equity or retained earnings on the balance sheet to get the job done.
  • if the Treasury Share Adjusted Debt to Shareholder Equity Ratio is less than 0.8, the company has a durable competitive advantage.

• Retained Earning:

  • One of the most important indicators of durable competitive advantage. Net earnings can be paid out as dividends, used to buy back shares or retained for growth.

  • If the company loses more than it has accumulated, retained earnings are negative.

  • If a company isn’t adding to its retained earnings, it isn’t growing its net worth.

  • The growth rate of retained earnings is a good indicator of whether it benefits from a competitive advantage.

  • Microsoft is negative because it chose to buyback stock and pay dividends

  • The more earnings retained, the faster it grows and increases the growth rate for future earnings.

• treasury stock

  • Carried on the balance sheet as a negative value because it represents a shareholder equity reduction.
  • Companies with moats have free cash, so treasury shares are the hallmark of durable competitive advantages.
  • When shares are bought back and held as treasury stock, it effectively decreases company equity. This increases the return on shareholders’ equity.
  • High return is a sign of competitive advantage. It’s good to know if it’s generated by financial engineering, exceptional business economics, or a combination.
  • To see which is which, convert the negative value of treasury shares into a positive one and add it to shareholders’ equity. Then divide net earnings by new shareholders’ equity. This will give the return on equity minus the effects of window dressing.
  • the presence of treasury shares and a history of buybacks are good indicators that the company has the competitive advantage

• preferred + common stock

  • in search for D.C.A., we look for the absence of preferred stock

• Return on Shareholder equity

  • d.c.a. show higher than average returns on shareholders’ equity
  • If the company shows a history of strong net earnings but shows lower equity, probably d.c.a. because strong companies don’t need to retain

D.C.A. and cash flow statement summary

• Capital Expenditures

  • Never invest in telephone companies because of big capital outlays

  • Important: 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 CAPEX for the ten-yr period and compare it with total net earnings over the same period

  • Important: if historically using less than 50%, then a good place to look for durable competitive advantage. If less than 25%, probably has a competitive advantage

• stock buybacks

  • an indicator of d.c.a. is a history of repurchasing/retiring its shares
  • Look at cash from investment activities. “Issuance (Retirement) of Stock, Net”

Quotes

“Occasionally even a company with a durable competitive advantage can screw up and do something stupid…Think New Coke.”

“The rule here is simple: Little or No Long-Term Debt Often Means a Good Long-Term Bet.”

“Since the future is largely unpredictable, we are usually compelled to take either the current and past earnings as a guide, and to use these figures as a base in making a reasonable estimate of future earnings. If there have been reasonably normal business conditions for a period of years, the average of the earnings over the period may afford a better index of earning power than the current figure alone.”

“Outside of the field of banks, insurance companies, and, particularly, investment trusts, it is only in the exceptional case that book value or liquidation value plays an important role in security analysis.”

“The book value of a common stock is usually not important, but it may be of interest where the book value is either much larger or much smaller than the market price.”

“The book value really measures, therefore, not what the stockholder could get out of their business (its liquidation value), but rather what they have put into the business, including undistributed earnings. The book value is of some importance in analysis because a very rough relationship tends to exist between the amount invested in a business and its average earnings.”

“To avoid being deceived by these devices, the investor must examine both the income and the surplus account over several years, and make due allowance for any amounts changed to surplus or reserves which really represent business losses during the period. Also…the investors should be particularly careful not to exaggerate the significance of a single year’s earnings.”

“The book value of a security is in most cases a rather artificial value.”

“During periods of depression it is particularly important to watch the cash account from year to year… In such periods the way in which the losses reflect themselves in the balance sheet may be more important than the amount of the losses themselves.”

“We suggest that the property account be neither accepted at face value nor entirely ignored, but that reasonable consideration be given to it in appraising the company’s securities.”

“..the success of an investment depends ultimately upon the future, future developments, and the future may never be forecast with accuracy. But if you have precise information as to a company’s present financial position and its past earnings record, you are better equipped to gauge its future possibilities.”

“When you know what the figures mean, you have a sound basis for good business judgment.”

“Ben Graham’s principle of always returning to the financial statements will keep an investor from making huge mistakes, and without huge mistakes the power of compounding can take over.” — Michael Price

“The investor who buys securities when the market price looks cheap on the basis of the company’s statements, and sells them when they look high on this same basis, probably will not make spectacular profits. But on the other hand, he will probably avoid equally spectacular and more frequent losses. He should have a better than average chance of obtaining satisfactory results. And this is the chief objective of intelligent investing.”

“When neither boom nor deep depression is affecting the market, the judgment of the public on individual issues, as indicated by market prices, is usually quite good. If the market price of some issue appears out of line with the facts and figures available, it will often be found later that the price is discounting future developments not then apparent on the surface. There is, however, a frequent tendency on the part of the stock market to exaggerate the significance of changes in earnings both in a favorable and unfavorable direction.” Investing is both Quantitative and Qualitative: “At bottom the ability to buy securities — particularly common stocks — successfully is the ability to look ahead accurately. Looking backward, however carefully, will not suffice, and may do more harm than good. Common stock selection is a difficult art — naturally, since it offers large rewards for success. It requires a skillful mental balance between facts of the past and the possibilities of the future.”

“The price of common stocks will depend…not so much on past or current earnings in themselves as upon what the security buying public thinks the future earnings will be… In the ordinary case the price of a common stock is the resultant of the many estimates of what the earnings are going to be in the next six months, in the next year, or even further in the future. Some of these estimates may be entirely incorrect and some may be exceedingly accurate; but the buying and selling by the many people who make these various estimates is what mainly determines the present price of a stock.”

“It is a common occurrence to find that the true value of a company’s assets is entirely different from the balance sheet total.”

“An investor should recognize a very strong distinction between good-will as it appears — or, more generally, fails to appear — on the balance sheet, and good-will as it is measured and reflected by the market price of the company’s securities.”

“It is the earning power of these intangibles rather than their balance sheet valuation, that really counts.”

“Warren has learned that time will make him superrich when he invests in a company that has a durable competitive advantage working in its favor.”

“The place that Warren goes to discover whether or not the company has a ‘durable’ competitive advantage is its financial statements.”

“When Warren is looking at a company’s financial statement, he is looking for consistency.”

“Warren knows that one of the great secrets to making more money is spending less money.”

“Warren has learned over the years that companies that are busy misleading the IRS are usually hard at work misleading their shareholders as well.”

“Some men read Playboy. I read annual reports.” (Warren Buffett)

References

• novelinvestor summary
• https://www.youtube.com/watch?v=jMuX_-hE7SQ&ab_channel=TheSwedishInvestor