Sunday, 18 September 2016
How do you identify an exceptional company with a durable competitive advantage from the SHAREHOLDERS' EQUITY OF THE BALANCE SHEET?
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.
The balance sheet is a snapshot of the company's financial condition on the particular date that the balance sheet is generated.
Assets minus Liabilities = Net worth or Shareholders' Equity
Shareholders’ Equity/Book Value
Shareholders’ Equity is accounted for under the headings of
· Capital Stock (Preferred and Common Stock);
· Paid in Capital and
· Retained Earnings
Shareholders’ Equity is an important number as it allows us to calculate the return on shareholders’ equity.
Return on shareholders’ equity is one of the ways we determine whether or not the company in question has a long-term competitive advantage working in it favour.
Preferred and Common Stock, Additional Paid in Capital
From a balance sheet perspective preferred and common stocks are carried on the books at their par value, and any money in excess of par that was paid in when the company sold the stock will be carried on the books as “paid in capital.”
If the company’s preferred stock has a par value of $100/share, and it sold it to the public at $120 a share, a $100 a share will be carried on the books under preferred stock and $20 a share will be carried under paid in capital.
The same thing applies to common stock, with say, a par value of $1 a share. If it is sold to the public at $10 a share, it will be booked on the balance sheet as $1 a share under common stock and $9 a share under paid-in capital.
Companies that have durable competitive advantage tend not to have any preferred stock.
This is in part because they tend not to have any debt.
They make so much money that they are self financing.
While preferred stock is technically equity, in that the original money received by the company never has to be paid back, it functions like debt in that dividends have to be paid out.
Interest paid on debt is deductible from pretax income.
However, dividends paid on preferred stock are not tax deductible, which tends to make issuing preferred shares very expensive money.
Because it is expensive money, companies like to stay away from it if they can.
One of the markers we look for in our search for a company with durable competitive advantage is the absence of preferred stock in its capital structure.
A company’s net earnings can either be paid out as dividends or used to buy back the company’s shares, or they can be retained to keep the business growing
When they are retained in the business, they are added to an account on the balance sheet, under shareholders’ equity called retained earnings.
If the earnings are retained and profitably put to us, they can greatly improve the long-term economic picture of the business.
To find the yearly net earnings that are going to be added to the company’s retained earnings pool, take the company’s after tax net earnings and deduct the amount that the company paid out in dividends and the expenditures in buying back stock that it had during the year.
Retained Earnings is an accumulated number, which means that each year’s new retained earnings are added to the total of accumulated retained earnings from all prior years.
If the company loses money, the loss is subtracted from what the company has accumulated in the past.
If the company loses more money than it has accumulated, the retained earnings number will show up as negative.
Retained Earnings is one of the most important number, on the balance sheet that can help us determine whether the company has a durable competitive advantage.
If a company is not making additions to its retained earnings, it is not growing its net worth.
If it is not growing its net worth, it is unlikely to make any of us super rich over the long run.
Simply put: the rate of growth of a company’s retained earnings is a good indicator whether or not it is benefiting from having a durable competitive advantage.
Not all growth in retained earnings is due to an incremental increase in sales of existing products; some of it is due to the acquisitions of other businesses.
When two companies merge, their retained earnings pools are joined, which creates an even larger pool.
General Motors and Microsoft both show negative retained earnings.
General Motors: it shows a negative number because of the poor economics of the auto business, which causes the company to lose billions.
Microsoft: it shows a negative number because it decided that its economic engine is so powerful that it doesn’t need to retain the massive amount of capital it has collected over the years and has instead chosen to spend its accumulated retained earnings and more on stock buybacks and dividend payments to its shareholders.
Berkshire Hathaway: Warren Buffett stopped its dividend payments the day he took control of the company. This allowed 100% of the company’s yearly net earnings to be added into the retained earnings pool. As opportunities showed up, he invested the company’s retained earnings in businesses that earned even more money and that money was all added back into the retained earnings pool and eventually invested in even more money making operations. As time went on, Berkshire’s growing pool of retained earnings increased its ability to make more and more money.
From 1965 to 2007, Berkshire’s expanding pool of retained earnings helped grow its pretax earnings from $4 a share in 1965 to $13,023 a share in 2007, which equates to an average annual growth rate of approximately 21%.
The more earnings that a company retains, the faster it grows its retained earnings pool, which in turn will increase the growth rate for future earnings.
The catch is, it has to keep buying companies that have a durable competitive advantage.
When a company buys back its own shares, it can do two things with them.
It can cancel them (and the shares cease to exist) or it can retain them with the possibility of reissuing them later on (and they are carried on the balance sheet under shareholders’ equity, as treasury stock).
Shares held as treasury stock have no voting rights, nor do they receive dividends and though arguably an asset, they are carried on the balance sheet at a negative value because they represent a reduction in the shareholder’s equity.
Companies with a durable competitive advantage because of their great economics, tend to have lots of free cash that they can spend on buying back their shares.
One of the hallmarks of a company with a durable competitive advantage is the presence of treasury shares on the balance sheet.
When a company buys its own shares, and holds them as treasury stock, it is effectively decreasing the company’s equity, which increases the company’s return on shareholders’ equity.
Since a high return on shareholders’ equity is one sign of a durable competitive advantage, it is good to know if the high returns on equity are being generated by financial engineering or exceptional business economics or because of a combination of the two.
To see which is which, convert the negative value of the treasury shares into a positive number and add it to the shareholders’ equity instead of subtracting it.
Then divide the company’s net earnings by the new total shareholders’ equity.
This will give us the company’s return on equity minus the effects of financial engineering.
Treasury shares are not part of the pool of the outstanding shares, when it comes to determining control of the company.
The presence of treasury shares on the balance sheet and a history of buying back shares, are good indicators that the company in question has a durable competitive advantage working in its favour.
Return on Shareholders’ Equity
Shareholders’ equity equal to the total sums of preferred and common stock, plus paid in capital, plus retained earnings and less treasury stock.
Shareholders in a company would be interested in how good a job management does at allocating their money so that they can earn even more.
Financial analysts developed the return on shareholders’ equity equation to test management’s efficiency in allocating the shareholders’ money.
It measures the management’s ability to profitably put shareholders’ equity to good use.
Warren Buffett use the return on shareholders’ equity in his search for the company with a durable competitive advantage.
Return on Shareholders’ Equity = Net Earnings / Shareholders’ Equity
Companies that benefit from a durable or long term competitive advantage show higher than average returns on shareholders’ equity.
Companies with no sustainable competitive advantage tend to have low returns on equity.
High returns on equity mean that the company is making good use of the earnings that it is retaining.
As time goes by, these high returns on equity will add up and increase the underlying value of the business, which over time, will eventually be recognized by the stock market through an increasing price for the company stock.
Some companies are so profitable that they don’t need to retain any earnings, so they pay them all out to the shareholders.
In these cases, its shareholders’ equity may be a negative number.
Insolvent companies will also show a negative number for shareholders’ equity.
If the company shows a long history of strong net earnings, but shows a negative shareholders’ equity, it is probably a company with a durable competitive advantage.
If the company shows both negative shareholders’ equity and a history of negative net earnings, we are probably dealing with a mediocre business that is getting beaten up by the competition.
High returns on shareholders equity means “come play.”
Low returns on shareholders equity means “stay away.”
Leverage is the use of debt to increase the earnings of the company.
A company using leverage can increase its earnings and its return on equity.
The problem with leverage is that it can make the company appear to have some kind of competitive advantage when it, in fact is just using large amounts of debt.
Wall Street investment banks are notorious for the use of very large amounts of leverage to generate earnings.
It creates the appearance of some kind of durable competitive advantage, even if there isn’t one.
In assessing the quality and durability of a company’s competitive advantage, avoid businesses that use a lot of leverage to help them generate earnings.
In the short run they appear to be the goose that lays the golden eggs, but at the end of the day, they are not.