How do you identify an exceptional company with a durable competitive advantage?
Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.
CASH FLOW STATEMENTS
The cash flow statement keeps track of the actual cash that flows in and out of the business.
A company can have a lot of cash coming in, through the sale of shares or bonds and still not be profitable.
A company can be profitable with a lot of sales on credit and not a lot of cash coming in.
The cash flow statement will tell us if the company is bringing in more cash than it is spending (“positive cash flow”) or if it is spending more cash than it is bringing in (“negative cash flow”).
Cash flow statements like income statements cover a set period of time.
The cash flow statement has three sections:
· Cash flow from operating activities
· Cash flow from investing activities
· Cash flow from financing activities
Cash flow from operating activities
Net income + depreciation & amortization = Total Cash from Operating Activities
Depreciation and amortization are real expenses from an accounting point of view.
They don't use up any cash because they represent cash that was spent years ago.
Cash flow from investing activities
This area includes an entry for all capital expenditures made for that accounting period.
Capital expenditure is always a negative number because it is an expenditure which causes a depletion of cash.
Total Other Investing Cash Flow Items adds up all the cash that gets expended and brought in, from the buying and selling of income producing assets.
If more cash is expended than is brought in, it is a negative number.
If more cash is brought in than is expended, it is a positive number.
Capital Expenditure + Other Investing Cash Flow Items = Total Cash from Investing Activities
Cash flow from financing activities
This measures the cash that flows in and out of a company because of financing activities.
This includes all outflows of cash for the payment of dividends.
It also includes the selling and buying of the company’s stock.
When the company sells shares to finance a new plant, cash flows into the company.
When the company buys back its shares, cash flows out of the company.
The same thing happens with bonds.
Sell a bond and cash flows in; buy back a bond and cash flows out.
Cash Dividends Paid + Issuance (Retirement) of Stock, Net + Issuance (Retirement) of Debt, Net = Total Cash from Financing Activities
Net Change in Cash
Total Cash from Operating Activities + Total Cash from Investing Activities + Total Cash from Financing Activities = Net Change in Cash
Some of the information found on a company’s cash flow statement can be very useful in helping us determine whether or not the company in question is benefiting from having a durable competitive advantage.
Capital Expenditures
Capital expenditures are outlays of cash or the equivalent in assets that are more permanent in nature – held longer than a year – such as property, plant and equipment.
They also include expenditures for such intangibles as patents.
They are assets that are expensed over a period of time greater than a year through depreciation and amortization.
Capital expenditures are recorded on the cash flow statement under investment operations.
When it comes to making capital expenditures, not all companies are created equal.
Many companies must make huge capital expenditures just to stay in business.
If the capital expenditures remain high over a number of years, they can start to have deep impact on earnings.
As a rule, a company with durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a competitive advantage.
Coca Cola spent 19% of its last ten years total earnings for capital expenditure. Moody spent 5% of its total earnings for the last ten years for capital expenditure.
GM used 444% more for capital expenditure than it earned over the last ten years. Goodyear (tire maker) used 950% more for capital expenditure than it earned over the last ten years.
For GM and Goodyear, where did all that extra money come from?
It came from bank loans and from selling tons of new debt to the public.
Such actions add more debt to these companies’ balance sheets, which increases the amount of money they spend on interest payments and this is never a good thing.
Both Coke and Moody’s, however, have enough excess income to have stock buyback programs that reduce the number of shares outstanding, while at the same time either reducing long-term debt or keeping it low.
Both these activities helped to identify the businesses with a durable competitive advantage working in their favour.
When looking at capital expenditures in relation to net earnings, add up a company’s total capital expenditures for a ten year period and compare the figure with the company’s total net earnings for the same ten year period.
The reason we look at a ten year period is that it gives us a really good long term perspective as to what is going on with the business.
Historically, durable competitive advantage companies used a far smaller percentage of their net income for capital expenditures.
If a company is historically using 50% of less of its annual net earnings for capital expenditures, it is a good place to look for a durable competitive advantage.
If it is consistently using less than 25% of its net earnings for capital expenditures, that scenario occurs more than likely because the company has a durable competitive advantage working in its favour.
Stock Buybacks
Companies that have a durable competitive advantage working in their favour make a ton of money.
The companies can sit on this cash, or they can reinvest it in the existing business or find a new business to invest in.
If they don’t require the cash for the above, they can also either pay it out as dividends to their shareholders or use it to buy back shares.
Shareholders have to pay income tax on the dividends. This doesn’t make anyone happy.
A neater trick is to use some of the excess money that the company is throwing off to buy back the company’s shares.
This reduces the number of outstanding shares – which increases the remaining shareholders’ interest in the company – and increases the per share earnings of the company, which eventually makes the stock price go up.
If the company buys back its own shares it can increase its per share earnings figure even though actual net earnings don’t increase.
The best part is that there is an increase in the shareholders’ wealth that they don’t have to pay taxes on until they sell their stock.
To find out if a company is buying back its shares, go to the cash flow statement and look under Cash from Investing Activities, under a heading titled “Issuance (Retirement) of Stock, Net”.
This entry nets out the selling and buying of the company’s shares.
If the company is buying back its shares year after year, it is a good bet that it is a durable competitive advantage that is generating all the extra cash that allows it to do so.
One of the indicators of the presence of a durable competitive advantage is a “history” of the company repurchasing or retiring its shares.
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