Below is a Summary of what Warren Buffett targets in a company’s three Financial Statements and his use of his Equity Bond Theory in order to evaluate a company and to determine a preferable purchase price.
In my opinion, one could regard all these requirements as a form of COMPANY ANALYSIS TEMPLATE with which an Industrial type company should comply in order to satisfy Buffett’s Investment Criteria, which should, in turn, lead to a profitable long-term investment.
GROSS PROFIT :- Gross Profit = Cost of Sales/Revenue >40%
SG&A EXPENSES :- SG&A < 30% x Gross Profit
R&D EXPENSES :- Little or Nil
DEPRECIATION :- Depreciation < 10% x Gross Profit
INTEREST EXPENSE :- Interest Expense < 15% x Operating Income (i.e. EBIT)
PRETAX INCOME :- VERY IMPORTANT NUMBER, especially for previous 12 months
NET EARNINGS :- Net Earnings > 20% x Total Revenue
EARNINGS PER SHARE :- 10 Year Trend showing Consistency & Upward Trend
CASH & SHORT TERM INVESTMENTS :- Ongoing increase from Business Operations NOT from One-Time events
INVENTORY :- Corresponding Rise in both Inventory & Net Earnings
CURRENT RATIO :- Current Assets/Current Liabilities < 1, due to Strong Earning Power
PROPERTY, PLANT & EQUIPMENT :- Low as possible
LONG TERM INVESTMENTS :- Large as possible. Should be Quality Investments, preferably in other DCA companies
RETURN ON ASSETS (ROA) :- High BUT with Large Total Assets to reduce Vulnerability
SHORT TERM DEBT :- Avoid bigger borrowers of Short Term money rather than Long term money
LONG TERM DEBT DUE :- Little or Nil
LONG TERM DEBT :- Long Term Debt < 3 x Annual Net Earnings
DEBT/SHAREHOLDER’S EQUITY :- Debt/S.H.Equity < 0.8 where S.H.Equity INCLUDES Value of Treasury Stock
PREFERRED STOCK :- Nil
RETAINED EARNINGS :- Annual Increase > 7%
TREASURY STOCK :- Should appear and be regularly purchased
RETURN ON SHAREHOLDER’S EQUITY (ROE) :- Net Income/S.H.Equity > 25%
CASH FLOW STATEMENT.
INVESTING OPERATIONS :- Based on +/-10 Year Period, Capital Expenditure/Net Earnings < 50%
For DCA company this ratio is consistently < 25%.
FINANCING ACTIVITIES :- “Issuance (Retirement) of Stock, Net” to be a regular NEGATIVE Value.
This indicates a NET Buying Back of its own Shares compared to a NET Issuance of its Shares.
BUFFET’S EQUITY BOND.
Companies with DURABLE COMPETITIVE ADVANTAGE (DCA) can be seen as an EQUITY BOND with a COUPON.
Equity Bond = Share Price
Bond Coupon = Pretax Earnings/Share
DETERMINE SHARE PRICE.
Stock Market will price a DCA company’s Equity Bond at a level that approximately reflects the Value of its Earnings RELATIVE to the Yield on LONG TERM CORPORATE BONDS (LTCB)
Equity Bond = Share Price = Coupon Rate/Long Term Corporate Bond Rate (LTCBR)
Coupon Rate/LTCBR = Pretax Earnings/LTCBR
WHEN TO BUY.
(1) Buy during Bear Markets or when share prices are depressed due to no fault of the company
(2) Buy when Share Price < Pretax Earnings per Share/LTCBR by a reasonable discount
WHEN TO SELL.
(1) Sell when presented with a BETTER company at a BETTER Price
(2) Sell when a current DCA company is losing its Durable Competitive Advantage
(3) Sell during Bull Markets or when prices are at unrealistically HIGH levels
(4) Sell when P/E ratios > 40+, especially if the stock’s price far EXCEEDS THE LONG-TERM ECONOMIC REALITIES OF THE BUSINESS