| name | buffett-financials |
| description | Interpret financial statements through Warren Buffett's durable competitive advantage lens — income statement, balance sheet, and cash flow analysis with the equity bond valuation framework. Use this skill when evaluating a company's financial health or screening for a long-term investment. |
| allowed-tools | yfinance_*, Bash, Read, qmd_* |
Buffett's Interpretation of Financial Statements
Framework from Warren Buffett and the Interpretation of Financial Statements by Mary Buffett and David Clark (Scribner, 2008).
Core Concept: Durable Competitive Advantage (DCA)
Warren divides businesses into two groups: those with a durable competitive advantage and those without. The DCA creates monopoly-like economics — the company can charge more or sell more than competitors. Durability (consistency over time) is the key to wealth creation.
Three business models that produce a DCA
- Sells a unique product — Coca-Cola, Wrigley, Hershey, P&G, Philip Morris
- Sells a unique service — Moody's, H&R Block, American Express (institutional-specific, NOT people-specific)
- Low-cost buyer & seller of a product/service the public consistently needs — Wal-Mart, Costco, Burlington Northern
Income Statement
| ($ in millions) | |
|---|
| Revenue | $10,000 |
| Cost of Goods Sold | 3,000 |
| Gross Profit | 7,000 |
| Operating Expenses | |
| Selling, General & Admin. | 2,100 |
| Research & Development | 1,000 |
| Depreciation | 700 |
| Operating Profit | 3,200 |
| Interest Expense | 200 |
| Gain (Loss) Sale Assets | 1,275 |
| Other | 225 |
| Income Before Tax | 1,500 |
| Income Taxes Paid | 525 |
| Net Earnings | $975 |
Gross Profit Margin
Formula: Gross Profit ÷ Total Revenues = Gross Profit Margin
DCA examples: Coca-Cola 60%+, Moody's 73%, Burlington Northern 61%, Wrigley 51%
Non-DCA examples: United Airlines 14%, GM 21%, U.S. Steel 17%, Goodyear 20%
Rule: ≥ 40% → possible DCA; below 40% → competitive industry; ≤ 20% → fiercely competitive. Track 10 years for consistency.
Selling, General & Administrative
As % of gross profit: Moody's 25%, Coca-Cola 59%, P&G 61%. Companies without DCA show wild variation (GM 28-83%, Ford 89-780%).
Rule: Under 30% is fantastic. 30-80% can still be DCA. Near/exceeding 100% → highly competitive.
Research & Development
Companies that must spend heavily on R&D have an inherent flaw — patents expire, tech gets replaced.
Merck: 29% of gross profit on R&D + 49% on SGA = 78% total. Intel: ~30% on R&D. Moody's: no R&D. Coca-Cola: no R&D.
Rule: Heavy R&D = long-term economics at risk. Warren is not interested.
Depreciation
Warren believes depreciation is a very real expense. DCA companies have lower depreciation as % of gross profit: Coca-Cola ~6%, Wrigley ~7%, P&G ~8%. GM: 22-57%.
Warren on EBITDA: "Using EBITDA, our clever Wall Street types are ignoring that eventually the printing press will wear out."
Interest Expense
DCA companies carry little/no interest expense. P&G: 8% of operating income. Wrigley: 7%. Goodyear: 49%.
Southwest Airlines: 9% (competitive advantage in its industry) vs United 61% vs American 92%.
Rule: In any industry, the company with the lowest ratio of interest payments to operating income usually has the competitive advantage.
Net Earnings
Rule: > 20% net earnings on total revenues → good chance of DCA. < 10% → highly competitive.
Coca-Cola: 21%, Moody's: 31%, Southwest: 7%, GM: 3%.
Exception: banks/financial companies — high ratio can mean slacking in risk management.
Per-Share Earnings
10 years of consistent upward trend = DCA. Erratic earnings with losses = highly competitive industry prone to boom/bust.
Balance Sheet
Cash & Cash Equivalents
Lots of cash + little/no debt from ongoing operations (not one-time events) → DCA. Check 7 years of balance sheets.
Inventory
DCA products never become obsolete. Inventory and net earnings rising together → profitable growth. Wild swings → boom/bust.
Property, Plant & Equipment
DCA companies don't constantly upgrade. Wrigley builds a gum plant and uses it until it wears out. GM constantly retools.
Long-Term Debt
Rule: DCA companies carry little or no long-term debt. Should be able to pay off all long-term debt within 3-4 years of net earnings.
Coca-Cola and Moody's: 1 year. Wrigley and Wash Post: 2 years. GM/Ford: couldn't pay it off with 10 years of earnings.
Treasury Stock
Presence of treasury shares + history of buybacks = good indicator of DCA.
Retained Earnings
Rate of growth is a good DCA indicator: Coke 7.9%, Wrigley 10.9%, Burlington Northern 15.6%, Wells Fargo 14.2%, Berkshire 23%.
Return on Shareholders' Equity
Formula: Net Earnings ÷ Shareholders' Equity = ROE
DCA examples: Coca-Cola 30%, Wrigley 24%, Hershey 33%, Pepsi 34%.
Non-DCA: United (profitable year) 15%, American 4%.
Rule: High returns on equity → "come play." Low returns → "stay away."
Debt to Shareholders' Equity Ratio
Formula: Total Liabilities ÷ Shareholders' Equity
Problem for DCA identification: DCA companies buy back shares, reducing equity, inflating the ratio. Moody's has negative equity.
Solution — Treasury Share-Adjusted Ratio: Add treasury stock back to shareholders' equity, then recalculate.
Adjusted ratios: P&G .71, Wrigley .68, Goodyear 4.35, Ford 38.0.
Rule (non-financial): Adjusted D/E below .80 → good chance of DCA.
Current Ratio
DCA companies often have current ratios below 1.0. Moody's .64, Coca-Cola .95, P&G .82.
Rule: Of little use in identifying DCA — their earning power lets them cover liabilities easily.
Leverage
Avoid businesses that use lots of leverage to generate earnings. Leverage can make a mediocre company appear to have a competitive advantage.
Cash Flow Statement
Capital Expenditures
Key metric: Add total capex for 10 years and compare to total net earnings for same period.
DCA examples: Coca-Cola 19%, Moody's 5%, Wrigley 49%, Altria 20%, P&G 28%, Pepsi 36%, Amex 23%.
Non-DCA: GM 444%, Goodyear 950%.
Rule: ≤ 50% of net earnings for capex → good place to look for DCA. ≤ 25% → more than likely has DCA.
Stock Buybacks
History of repurchasing shares → good DCA indicator. Look on cash flow statement under "Issuance (Retirement) of Stock, Net."
Valuation: The Equity Bond
A DCA company's shares = an "equity bond" with an ever-increasing coupon.
- The "bond" = the company's shares/equity
- The "coupon" = the company's pretax earnings (not dividends)
- The yield = Pretax Earnings per share ÷ Purchase Price per share
Equity Bond Value = Pretax Earnings per share ÷ Long-Term Corporate Bond Rate
Example (Coca-Cola 2007): Pretax $3.96 ÷ 6.5% = ~$60/share. Stock traded $45-64.
The DCA causes earnings to increase year after year. The stock market eventually revalues the shares to reflect this.
When to Buy
- Lower price → better long-term return
- Buy in bear markets
- Buy when a great business confronts a one-time solvable problem
- Stay away at bull market peaks with historically high P/Es
When to Sell
- Need money for an even better company at a better price
- Company appears to be losing its DCA
- P/E reaches 40+ in a raging bull market (sell and put proceeds in Treasuries; wait for next bear market)
Quick-Reference: DCA Indicators
| Metric | What to Look For |
|---|
| Gross Profit Margin | ≥ 40%, consistent for 10 years |
| Net Earnings / Revenue | > 20% (non-financial) |
| Capex / Net Earnings | ≤ 50%; ≤ 25% is ideal |
| Long-Term Debt | Payable in 3-4 years of earnings |
| Adjusted D/E Ratio | < .80 (non-financial) |
| ROE | Consistently high (e.g., 20%+) |
| R&D | Low or none |
| Interest / Operating Income | Lowest in industry |
| Per-Share Earnings | 10-year consistent upward trend |
| Retained Earnings Growth | Positive, consistent growth |
| Share Buybacks | History of repurchasing shares |
| Cash + Debt | Lots of cash, little/no debt from operations |
