💰 Balance sheet analysis Buffett 💰
𝐕𝐀𝐋𝐔𝐄 𝐈𝐍𝐕𝐄𝐒𝐓𝐈𝐍𝐆 - 𝐖𝐀𝐑𝐑𝐄𝐍 𝐁𝐔𝐅𝐅𝐄𝐓𝐓
"Risk arises when you don't know what you're doing" - quote Warren Buffett
Warren Buffett is the father of value investing. In doing so, he expanded on the ideas of the "forefather" of value thinking, Benjamin Graham. In this article I would like to introduce you to Buffett's investment approach and the basic idea of value investing.
Also due to the economic developments of the last time the Value Investing comes more and more into the focus. -->Away from Growth, towards Value!
Our Oracle of Omaha, as he likes to be called, is basically interested in finding companies that have a decisive competitive advantage. This is reflected in the business model or qualitative factors, but of course also on the basis of bare figures (quantitative).
The questions that value investors and thus Buffett always ask themselves are basically the following [1]:
1. how do I recognize an exceptional company with a sustainable competitive advantage?
2) How do I value a company with a sustainable competitive advantage?
So what exactly is Warren Buffett looking at now? What is important to him? What should a die-hard value investor (Yes I am!) look for?
In the following, I would like to explain to you how this strategy works and how Buffett uses business reports to put his strategy into practice. The collection of key figures and facts should hopefully also help you to find exciting companies.
𝗜. 𝗤𝘂𝗮𝗹𝗶𝘁𝗮𝘁𝗶𝘃𝗲 𝗙𝗮𝗸𝘁𝗼𝗿𝗲𝗻: Where does our dear Warren even begin to look for exceptionally good companies?
Buffett has found that such "super companies" take the form of three basic business models [1]:
-they sell a unique product or
-they sell a unique service or
-they are the lowest cost buyer and seller of a product or service that the general public always needs.
Classic examples:
Coca Cola, Pepsi, Wrigley, Procter & Gamble, Washington Post, American Express, Mastercard, Walmart, etc.
These companies have virtually implanted the story of their products into our heads (Coca Cola, Pepsi, Wrigleys, etc.) and have gotten us to the point where we think of their products when we want to satisfy a need. Likewise, one or the other is the lowest priced buyer and seller of a product or service (Walmart, for example). Here, margins are abandoned in favor of quantity [1].
Now we know what qualitative factors are important (not conclusively). But where does Warren look in the annual reports for the crucial clues?
𝗜𝗜. 𝗤𝘂𝗮𝗻𝘁𝗶𝘁𝗮𝘁𝗶𝘃𝗲 𝗙𝗮𝗸𝘁𝗼𝗿𝗲𝗻: How does Buffett look at annual reports?
Buffett looks closely at the following three parts of the annual report:
-Income Statement (Income Statement).
-Balance Sheet (Balance Sheet)
-Cash Flow Statement (Cash Flow Statement)
I would now like to explain a few key figures and criteria of the three sections in more detail. You are welcome to use this smorgasbord to search for great companies yourself [1].
Income Statement:
-Gross profit margin at least 40% -->high margins indicate high pricing power! Competitive advantage!
-sales/administration and other overheads max 30-40% of gross profit, as these do not generate any operational added value.
-Expenses in...
...research and development as low as possible (long-term view), as high R&D costs may indicate high competition. → Cost-intensive business! Possibly no long-term competitive advantage!
...Depreciation as low as possible. Positive examples: Wrigley 7% of gross profit, Coca Cola 6%; negative example: GM 22-57% in the past (to be fair, of course, also capital-intensive industry)
...interest expense as low as possible (max 15% of operating profit). Thus also low debt. -->high debt increases risk and worsens net margin! -->no competitive advantage! Examples: P&G ca 8% (positive); Goodyear 49% (negative).
-Net income at least 20% of net sales -->high margin indicates flexibility. One is well equipped in crises and can still live well with lower margins. Competitive advantage!
-Net profit must be sufficient to pay off its debts within 3-4 years.
-Earnings per share in a 10-year horizon with a continuous upward trend.
Balance Sheet:
-Inventories: should increase together with profit. Higher inventory should indicate higher demand. However, higher inventories at lower profit could indicate slow-moving items that need to be written off. Possibly not getting certain inventory to customers, which doesn't bode well in the long run.
-->Property, plant and equipment: companies that do not have a long-term competitive advantage face constant competition, which means that in an attempt to remain competitive, they must constantly update their production equipment, often before it wears out. -->Stable products that you don't have to change therefore give you a competitive advantage. Good examples here are Coca Cola or Wrigleys.
Short-term debt < Long-term debt: If the ratio were reversed, it would mean pursuing a very aggressive financial policy. This may mean generating a lot of cash in the short term, but you are acting very risky in the long term. In financially difficult times, companies that take on long-term and thus predictable liabilities have a competitive advantage over their competitors.
-Treasury shares: Treasury shares can be recognized by the fact that they represent a negative item in equity. Companies with treasury shares on their balance sheet indicate a competitive advantage. Share buyback programs, which generate treasury shares in shareholders' equity, are deliberately aimed at sharholder value, as such buyback programs mean price maintenance. The company thus tends to be investor-friendly. Share buybacks are also tax-free for investors, unlike dividends (based on Germany).
-Dividend: No distributions from the company's substance/income. The following calculation should always end with a positive number:
Net income - Dividend - Share buybacks = Delta (positive good, negative bad). If the value is negative, this means nothing other than that the company is paying dividends out of its own substance. In the long term, this cannot go well!
Cash flow statement:
-Investment costs as low as possible (10 year perspective). -->Target <50% of net income. A good example is Moodys. Here, investment costs are about 5% of profit, which is very low. However, high investment is not bad per se. In the long term, however, this does not generate a competitive advantage, because you always have to use a lot of capital for the further development of the product/service ("With na Coke, you just don't need to invest much more" - positive!). In the short term, however, high investments can make sense. The trick also tends to be finding companies that don't need to invest a lot in the long run to make their business model work.
-Free cash flow: This is important for liquidity planning and shows what free cash flow is left over for dividends, share buybacks and repayment of debt (FCF = cash flow from operating activities - cash flow from investing activities).
I hope I was able to give you a good overview of what value investors look for. However, it has to be judged on a case-by-case basis whether you can overlook one or the other aspect. The key data I would like to give you are indications and not set in stone. Finally, there is no such thing as a perfect company that always meets all the criteria. There are always differences between industries. Capital-intensive companies in industry, for example, cannot be compared with tech companies, which tend to have better margins. That is in the nature of things.
Of course, this article is not exhaustive. There are many other things and key figures that you should pay attention to in each individual case. However, you can certainly do quite well with this list. Things that I have not gone into but are equally important for a value investor [2] [3]:
-Management: Is the company run by honest managers who act like owners?
-Understand the business model!-->This of course is independent of the investment approach.
-Valuation: Can the company's stock be bought at a price significantly below its intrinsic value? -->Company valuation (relative ratios such as P/E ratio, KUV, KCV, KBV, PEG ratio as well as the concrete company valuation using the DCF method).
Very briefly to the valuation: Here, too, the P/E ratio is always used (also by me). But be aware that the P/E ratio is only a relative valuation. It serves as a first assessment of the position, but does not reflect one thing: the development of the company in the future. Therefore, always distinguish between relative valuation (P/E, CUV, etc.) and intrinsic valuation (DCF, among others), which takes into account future cash flows and risk elements. Just because the relative valuation claims that the company is cheap/expensive, that is far from the case. Buffett likes to use the 10x pretax rule (EBT multiple, which should be <10) as an initial standpoint, but always emphasizes that a DCF valuation is essential. Relative valuation has many weaknesses (besides simplicity), unlike the intrinsic valuation methodology. Therefore, to at least begin to account for future growth, I would always include the PEG ratio in my repertoire. And even "the one and only" uses EBT multiples rather than the earnings multiple (P/E ratio) [4]. Why? I'll be happy to tell you in another post :)
I hope you enjoyed this post. Maybe you also have @Divmann has a nice addition (united in the Value Thought). If you are unclear about basic things, such as the structure of income statement, balance sheet, cash flow statement, feel free to give me feedback. If needed, I can also prepare a few posts on the basics, so you can better understand the Value idea. In this sense have a nice weekend :)
Books I would like to recommend to you about value investing (I only recommend books I have read myself):
-For beginners with basic knowledge: How Warren Buffet reads corporate numbers - Mary Buffet, David Clark.
-For advanced and expert readers: The little book of valuation - How to Value a Company, Pick a Stock, and Profit - Aswath Damodaran
Index for your own research at www:
-Value Investing
-The most important ratios for stocks
-The structure of an annual report
-Methods for company valuation: DCF, capitalized earnings value method, net asset value method, multiples, etc.
-Warren Buffett and Charlie Munger
-Benjamin Graham
Sources:
[1] Mary Buffett, David Clark; How Warren Buffett reads corporate numbers.
[3] http://www.valueinvesting.de/
[4] https://medium.com/@covenantlite/the-10x-pretax-income-multiple-bc201e3481cc
