buffett-financials

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

1. Sells a unique product — Coca-Cola, Wrigley, Hershey, P&G, Philip Morris
2. Sells a unique service — Moody's, H&R Block, American Express (institutional-specific, NOT people-specific)
3. Low-cost buyer & seller of a product/service the public consistently needs — Wal-Mart, Costco, Burlington Northern

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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.

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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.

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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."

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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.

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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

1. Need money for an even better company at a better price
2. Company appears to be losing its DCA
3. 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