Warren Buffett and the Interpretation of Financial Statements Book Summary
Omar Waller
Global Sales Ops and Continuous Improvement Leader | Engineer | Writer | KAΨ
In pursuit of a company with a durable competitive advantage…
Warren Buffett is known as one of the most successful investors of all time. His company, Berkshire Hathaway, earned a greater return on investment than the general market for many years. Warren is notorious for his surprisingly simple investment philosophy. This book outlines the key areas he looks at when evaluating a company for a durable competitive advantage.
When Warren invests, he is in it for the long run. He does not day trade. He spends a lot of time evaluating companies, invests large sums of money, and holds his position for decades. Therefore, he is on a search for companies that show signals of having a durable competitive advantage. To do this, he uses key metrics from the company's Income Statement, Balance Sheet, and Cash Flow Statement.
In this summary, I cover a few locations on each statement he reviews. Each metric must be evaluated against competitors in the same industry.?
My Top Points
#1 Where Warren Goes on the Income Statement
Gross Profit = Total Revenue - Cost of Goods Sold?
Gross Profit Margin = Gross Profit / Total Revenue
In Warren’s evaluation of companies, he found that businesses with a strong competitive advantage have higher Gross Profits and Margin than others in their industry. Companies with high Gross Profit generally have low costs. Meaning, they figured out a way to keep costs that go into making their product low, while still maintaining high revenues.
Net Earnings = Total Revenue - All Expenses
Net earnings tell Warren how much money a company has after subtracting Operating Expenses, Interest Expenses, and Income Taxes. After all bills are paid, how much we got? Companies with strong competitive advantages maintain high net earnings.
Per Share Earnings or Earnings Per Share (EPS) is the net earnings of a company based on the shares outstanding. Typically, a company’s EPS is tightly correlated to the company’s stock price. Warren is always on the lookout for companies with per share earnings trending upwards each year in a stable fashion. He avoids companies with highly volatile per share earnings. Volatile per share earnings tend to indicate a weak competitive advantage.
#2 Where Warren Goes on the Balance Sheet
Total Assets include items like Cash, Property/Plant/Equipment (PPE), Goodwill, Intangibles, and other liquid items owned by a company. Warren looks here to help determine the health of a company. Return on Assets (ROA) = Net Earnings / Total Assets. This performance metric indicates how well a company generates revenue using the assets they own. Well managed companies use their assets effectively to produce earnings for their company.?
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Total Liabilities are all the obligations companies have on their balance sheet. This includes debt, accounts payable, long-term debt, and others. Debt to Shareholders Equity = Total Liabilities / Shareholder’s Equity. Warren is not a huge fan of highly leveraged companies. He looks to invest in companies with a low Debt to Shareholder’s Equity.?
At the end of a quarter, net earnings are either paid out as dividends or retained/kept by the company to use elsewhere. When kept, these net earnings are denoted as Retained Earnings on the balance sheet. Warren loves companies who are able to retain earnings each quarter and year. This tends to indicate strong business operations and management.
Shareholders Equity = Total Assets - Total Liabilities
Return on Shareholders Equity = Net Earnings / Shareholders Equity
High return on Shareholder Equity indicates leadership is making good use of the equity owned by the company, including retained earnings. Therefore, Warren prefers companies with a high return. There is an exception. A company showing a negative Shareholder’s Equity may indicate the company’s retained earnings were paid out as dividends. This may mean the company is very successful/well managed. Warren keeps a lookout for companies with negative Shareholder’s equity.
#3 Where Warren Goes on the Cash Flow Statement
(1) Cash Flow from Operating Activities = Net Income + Depreciation + Amortization
(2) Cash Flow from Investing Operations = Capital Expenditures + Other Investing Cash Flow Items; always negative
(3) Cash Flow from Financing Activities = Cash Dividends Paid + Issuance of Stock + Issuance of Debt
Each of these performance metrics helps Warren determine if a company has a durable competitive advantage. Generally, Warren looks for companies that:
Warren prefers when companies buyback stock instead of issuing a dividend. Why? Shareholders must pay taxes on dividends received. Yet, no taxes are paid on an increase in stock price due to a higher EPS. Stock buybacks don’t always increase EPS, but at minimum, it indicates a company has enough retained earnings to do so, and strongly believes in the financial future of the company.?
Thanks for reading this edition of Waller’s Reading Room! If you enjoyed it or have thoughts, you can reply directly to this email and let me know. Don’t forget, I’m always taking recommendations, let me know what I should read next.
Yours Truly,
Omar Waller