VALUING THE COMPANY: Warren's revolutionary idea of the equity bond and how it has made him super-rich

VALUING THE COMPANY WITH A DURABLE COMPETITIVE ADVANTAGE

"I look for businesses in which I think I can predict what they're going to look like in ten to fifteen years' time. Take Wrigley's chewing gum. I don't think the Internet is going to change how people chew gum. "

WARREN BUFFETT

WARREN'S REVOLUTIONARY IDEA OF THE EQUITY BOND AND HOW IT HAS MADE HIM SUPERRICH

In the late 1980s, Warren gave a talk at Columbia University about how companies with a durable competitive advantage show such great strength and predictability in earnings growth (and) that growth turns their shares into a kind of equity bond, with an ever-increasing coupon or interest payment. The "bond" is the company's shares/equity, and the "coupon/interest payment" is the company's pretax earnings. Not the dividends that the company pays out, but the actual pretax earnings of the business.

This is how Warren buys an entire business: He looks at its pretax earnings and asks if the purchase is a good deal relative to the economic strength of the company's underlying economics and the price being asked for the business. He uses the same reasoning when he is buying a partial interest in a company via the stock market.

What attracts Warren to the conceptual conversion of a company's shares into equity/bonds is that the durable competitive advantage of the business creates underlying economics that are so strong they cause a continuing increase in the company's earnings. With this increase in earnings comes an eventual increase in the price of the company's shares as the stock market acknowledges the increase in the underlying value of the company.

Thus, at the risk of being repetitive, to Warren the shares of a company with a durable competitive advantage are the equivalent of equity/bonds, and the company's pretax earnings are the equivalent of a normal bond's coupon or interest payment. But instead of the bond's coupon or interest rate being fixed, it keeps increasing year after year, which naturally increases the equity/bond's value year after year.

This is what happens when Warren buys into a company with a durable competitive advantage. The per-share earnings continue to rise over time---either through increased business, expansion of operations, the purchase of new businesses, or the repurchase of shares with money that accumulates in the company's coffers. With the rise in earnings comes a corresponding increase in the return that Warren is getting on his original investment in the equity bond.

Let's look at an example to see how his theory works.

In the late 1980s, Warren started buying shares in Coca-Cola for an average price of $6.50 a share against pretax earnings of $.70 a share, which equates to after-tax earnings of $.46 a share. Historically, Coca-Cola's earnings had been growing at an annual rate of around 15%. Seeing this, Warren could argue that he just bought a Coca-Cola equity bond that is paying an initial pretax interest rate of 10.7% on his $6.50 investment. He could also argue that that yield would increase over time at a projected annual rate of 15%.

Understand that, unlike the Graham-based value investors, Warren is not saying that Coca-Cola is worth $60 and is trading at $40 a share; therefore it is "undervalued." What he is saying is that at $6.50 a share, he was being offered a relatively risk-free initial pretax rate of return of 10.7%, which he expected to increase over the next twenty years at an annual rate of approximately 15%. Then he asked himself if that was an attractive investment given the rate of risk and return on other investments.

To the Graham-based value investors, a pretax 10.7% rate of return growing at 15% a year would not be interesting since they are only interested in the stock's market price and, regardless of what happens to the business, have no intention of holding the investment for more than a couple of years. But to Warren, who plans on owning the equity bond for twenty or more years, it is his dream investment.

Why is it his dream investment? Because with each year that passes, his return on his initial investment actually increases, and in the later years the numbers really start to pyramid. Consider this: Warren's initial investment in The Washington Post Company cost him $6.36 a share. Thirty-four years later, in 2007, the media company is earning a pretax $54 a share, which equates to an after-tax return of $34 a share. This gives Warren's Washington Post equity bonds a current pretax yield of 849%, which equates to an after-tax yield of 534%. (And you were wondering how Warren got so rich!)

So how did Warren do with his Coca-Cola equity bonds?

By 2007 Coca-Cola's pretax earnings had grown at an annual rate of approximately 9.35% to $3.96 a share, which equates to an after-tax $2.57 a share. This means that Warren can argue that his Coke equity bonds are now paying him a pretax return of $3.96 a share on his original investment of $6.50 a share, which equates to a current pretax yield of 60% and a current after-tax yield of 40%.

The stock market, seeing this return, over time, will eventually revalue Warren's equity bonds to reflect this increase in value.

Consider this: With long-term corporate interest rates at approximately 6.5% in 2007, Warren's Washington Post equity bonds/shares, with a pretax $54 earnings/interest payment, were worth approximately $830 per equity bond/share that year ($54 / .065 = $830). During 2007, Warren's Washington Post equity bonds/shares traded in a range of between $726 and $885 a share, which is right about in line with the equity bond's capitalized value of $830 a share.

We can witness the same stock market revaluing phenomenon with Warren's Coca-Cola equity bonds. In 2007 they earned a pretax $3.96 per equity bond/share, which equates to an after-tax $2.57 per equity bond/share. Capitalized at the corporate interest rate of 6.5%, Coke's pretax earnings of $3.96 are worth approximately $60 per equity bond/share ($3.96 / .065 = $60). During 2007, the stock market valued Coca-Cola between $45 and $64 a share.

One of the reasons that the stock market eventually tracks the increase in these companies' underlying values is that their earnings are so consistent, they are an open invitation to a leveraged buyout. If a company carries little debt and has a strong earnings history, and its stock price falls low enough, another company will come in and buy it, financing the purchase with the acquired company's earnings. Thus when interest rates drop, the company's earnings are worth more, because they will support more debt, which makes the company's shares worth more. And when interest rates rise, the earnings are worth less, because they will support less debt. This makes the company's stock worth less.

What Warren has learned is that if he buys a company with a durable competitive advantage, the stock market, over time, will price the company's equity bonds/shares at a level that reflects the value of its earnings relative to the yield on long-term corporate bonds. Yes, some days the stock market is pessimistic and on others is full of wild optimism, but in the end it is long-term interest rates that determine the economic reality of what long-term investments are worth.

Durability is Warren's ticket to riches

DURABILITY IS WARREN'S TICKET TO RICHES

Warren has learned that it is the "durability" of the competitive advantage that creates all the wealth. Coca-Cola has been selling the same product for the last 122 years, and chances are good that it will be selling the same product for the next 122 years.

It is this consistency in the product that creates consistency in the company's profits. If the company doesn't have to keep changing its product, it won't have to spend millions on research and development, nor will it have to spend billions retooling its plant to manufacture next year's model. So the money piles up in the company's coffers, which means that it doesn't have to carry a lot of debt, which means that it doesn't have to pay a lot in interest, which means that it ends up with lots of money to either expand its operations or buy back its stock, which will drive up earnings and the price of the company's stock---which makes shareholders richer.

So when Warren is looking at a company's financial statement, he is looking for consistency. 

• Does it consistently have high gross margins? 
• Does it consistently carry little or no debt? 
• Does it consistently not have to spend large sums on research and development? 
• Does it show consistent earnings? 
• Does it show a consistent growth in earnings? 

It is this "consistency" that shows up on the financial statement that gives Warren notice of the "durability" of the company's competitive advantage.

The place that Warren goes to discover whether or not the company has a "durable" competitive advantage is its financial statements.

Where Warren starts his search for the exceptional company

WHERE WARREN STARTS His SEARCH FOR THE EXCEPTIONAL COMPANY

Before we start looking for the company that will make us rich, which is a company with a durable competitive advantage, it helps if we know where to look. Warren has figured out that these super companies come in three basic business models: 

(1) They sell either a unique product or 

(2) a unique service, or 

(3) they are the low-cost buyer and seller of a product or service that the public consistently needs.

Let's take a good look at each of them.

(1) Selling a unique product: This is the world of Coca-Cola, Pepsi, Wrigley, Hershey, Budweiser, Coors, Kraft, The Washington Post, Procter & Gamble, and Philip Morris. Through the process of customer need and experience, and advertising promotion, the producers of these products have placed the stories of their products in our minds and in doing so have induced us to think of their products when we go to satisfy a need. Want to chew some gum? You think of Wrigley. Feel like having a cold beer after a hot day on the job? You think of Budweiser. And things do go better with Coke.

Warren likes to think of these companies as owning a piece of the consumer's mind, and when a company owns a piece of the consumer's mind, it never has to change its products, which, as you will find out, is a good thing. The company also gets to charge higher prices and sell more of its products, creating all kinds of wonderful economic events that show up on the company's financial statements.

(2) Selling a unique service: This is the world of Moody's Corp., H&R Block Inc., American Express Co., The Service Master Co., and Wells Fargo & Co. Like lawyers or doctors, these companies sell services that people need and are willing to pay for---but unlike lawyers and doctors, these companies are institutional specific as opposed to people specific. When you think of getting your taxes done you think of H&R Block, you don't think of Jack the guy at H&R Block who does your taxes. When Warren bought into Solomon Brothers, an investment bank (now part of Citigroup), which he later sold, he thought he was buying an institution. But when top talent started to leave the firm with the firm's biggest clients, he realized it was people specific. In people-specific firms workers can demand and get a large part of the firm's profits, which leaves a much smaller pot for the firm's owners/shareholders. And getting the smaller pot is not how investors get rich.

The economics of selling a unique service can be phenomenal. A company doesn't have to spend a lot of money on redesigning its products, nor does it have to spend a fortune building a production plant and warehousing its wares. Firms selling unique services that own a piece of the consumer's mind can produce better margins than firms selling products.

(3) Being the low-cost buyer and seller of a product or service that the public has an ongoing need for: This is the world of Wal-Mart, Costco, Nebraska Furniture Mart, Borsheim's Jewelers, and the Burlington Northern Santa Fe Railway. Here, big margins are traded for volume, with the increase in volume more than making up for the decrease in margins. The key is to be both the low-cost buyer and the low-cost seller, which allows you to get your margins higher than your competitor's and still be the low-cost seller of a product or service. The story of being the best price in town becomes part of the consumer's story of where to shop. In Omaha, if you need a new stove for your home, you go the Nebraska Furniture Mart for the best selection and the best price. Want to ship your goods cross-country? The Burlington Northern Santa Fe Railway can give you the best deal for your money. Live in a small town and want the best selection with the best prices? You go to Wal-Mart.

It's that simple: Sell a unique product or service or be the low-cost buyer and seller of a product or service, and you get to cash in, year after year, just as though you broke the bank at Monte Carlo.

FINANCIAL STATEMENT OVERVIEW: where the gold is hidden

FINANCIAL STATEMENT OVERVIEW: WHERE THE GOLD Is HIDDEN

Financial statements are where Warren mines for companies with the golden durable competitive advantage. It is the company's financial statements that tell him if he is looking at a mediocre business forever moored to poor results or a company that has a durable competitive advantage that is going to make him superrich.

Financial statements come in three distinct flavors:

First, there is the Income Statement: The income statement tells us how much money the company earned during a set period of time. The company's accountants traditionally generate income statements for shareholders to see for each three month period during the fiscal year and for the whole fiscal year. Using the company's income statement, Warren can determine such things as the company's margins, its return equity, and, most important, the consistency and direction of its earnings. All of these factors are necessary in determining whether the company is benefiting from a durable competitive advantage.

The second flavor is the Balance Sheet: The balance sheet tells us how much money the company has in the bank and how much money it owes. Subtract the money owed from the money in the bank and we get the net worth of the company. A company can create a balance sheet for any given day of the year, which will show what it owns, what it owes, and its net worth for that particular day.

Traditionally, companies generate a balance sheet for shareholders to see at the end of each three-month period of time (called quarter) and at the end of the accounting or fiscal year. Warren has learned to use some of the entries on the balance sheet-such as the amount of cash the company has or the amount of long-term debt it carries---as indicators of the presence of a durable competitive advantage.

Third, there is the Cash Flow Statement: The cash flow statement tracks the cash that flows in and out of the business. The cash flow statement is good for seeing how much money the company is spending on capital improvements. It also tracks bond and stock sales and repurchases. A company will usually issue a cash flow statement along with its other financial statements.

In the chapters ahead we shall explore in detail the income statement, balance sheet, and cash flow statement entries and indicators that Warren uses to discover whether or not the company in question has a durable competitive advantage that will make him rich over the long run.

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WHERE WARREN GOES TO FIND FINANCIAL INFORMATION

In the modern age of the Internet there are dozens of places where one can easily find a company's financial statements. The easiest access is through either MSN.com (http://money central.msn.com/investor/home.asp) or Yahoo's Finance web page (www.finance.yahoo.com).

We use both, but Microsoft Network's MSN.com has more detailed financial statements. To begin, find where you type in the symbol for the stock quotes on both sites, then type in the name of the company. Click it when it pops up, and both MSN and Yahoo! will take you to that company's stock quote page. On the left you'll find a heading called "Finance," under which are three hyperlinks that take you to the company's balance sheet, income statement, and cash flow. Above that, under the heading "SEC," is a hyperlink to documents filed with the U.S. Securities and Exchange Commission (SEC). All publicly traded companies must file quarterly financial statements with the SEC; these are known as 8Qs. Also filed with the SEC is a document called the 10K, which is the company's annual report. It contains the financial statements for the company's accounting or fiscal year. Warren has read thousands of 10Ks over the years, as they do the best job of reporting the numbers without all the fluff that can get stuffed into a shareholders' annual report.

For the hard-core investor Bloomberg.com offers the same services and a lot more, for a fee. But honestly, unless we are buying and selling bonds or currencies, we can get all the financial information we need to build a stock portfolio for free from MSN and Yahoo! And "free" financial information always makes us smile!

CAPITAL EXPENDITURES: not having them is one of the secrets to getting rich

CAPITAL EXPENDITURES: NOT HAVING THEM IS ONE OF THE SECRETS TO GETTING RICH

Cash Flow Statement
($ in millions)
-> Capital Expenditures	($1,648)
Other Investing Cash Flow Items	(5,071)
Total Cash from Investing Activities	($6,719)

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. Basically they are assets that are expensed over a period of time greater than a year through depreciation or amortization. Capital expenditures are recorded on the cash flow statement under investment operations.

Buying a new truck for your company is a capital expenditure, the value of the truck will be expensed through depreciation over its life---let's say six years. But the gasoline used in the truck is a current expense, with the full price deducted from income during the current year.

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 capital expenditures remain high over a number of years, they can start to have deep impact on earnings. Warren has said that this is the reason that he never invested in telephone companies---the tremendous capital outlays in building out communication networks greatly hamper their long-term economics.

As a rule, a company with a durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a competitive advantage. Let's look at a couple of examples.

Coca-Cola, a long-time Warren favorite, over the last ten years earned a total $20.21 per share while only using $4.01 per share, or 19% of its total earnings, for capital expenditures for the same time period. Moody's, a company Warren has identified as having a durable competitive advantage, earned $14.24 a share over the last ten years while using a minuscule $0.84 a share, or 5% of its total earnings, for capital expenditures.

Compare Coke and Moody's with GM, which over the last ten years earned a total $31.64 a share after subtracting losses, while burning through a whopping $140.42 a share in capital expenditures. Or tire-maker Goodyear, which over the last ten years earned a total of $3.67 a share after subtracting losses and had total capital expenditures of $34.88 a share.

If GM used 444% more for capital expenditures than it earned, and Goodyear used 950%, 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, which 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 actions are big positives to Warren, and both helped him identify Coca-Cola and Moody's as businesses with a durable competitive advantage working in their favor.

When we look at capital expenditures in relation to net earnings we simply 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. For instance, Wrigley annually uses approximately 49% of its net earnings for capital expenditures. Altria uses approximately 20%; Procter & Gamble, 28%; PepsiCo, 36%; American Express, 23%; Coca-Cola, 19%; and Moody's, 5%.

Warren has discovered that if a company is historically using 50% or 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 favor.

And having a durable competitive advantage working in our favor is what it is all about.

The Problems with Leverage and the tricks it can play on you

THE PROBLEM WITH LEVERAGE AND THE TRICKS IT CAN PLAY ON YOU

Leverage is the use of debt to increase the earnings of the company. The company borrows $100 million at 7% and puts that money to work, where it earns 12%. This means that it is earning 5% in excess of its capital costs. The result is that $5 million is brought to the bottom line, which increases earnings and 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. In their case they borrow $100 billion at, let us say, 6% and then loan it out at 7%, which means that they are earning 1% on the $100 billion, which equates to $1 billion. If that $1 billion shows up year after year, it creates the appearance of some kind of durable competitive advantage, even if there isn't one.

The problem is that while it appears that the investment bank has consistency in its income stream, the actual source that is sending it the interest payments may not be able to maintain the payments. This happened in the recent subprime-lending crisis that cost the banks hundreds of billions of dollars. They borrowed billions at, say, 6% and loaned it out at 8% to subprime homebuyers, which made them a ton of money. But when the economy started to slip, the subprime home-buyers started to default on their mortgages, which meant they stopped making interest payments. These subprime borrowers did not have a durable source of income, which ultimately meant that the investment banks didn't either.

In assessing the quality and durability of a company's competitive advantage, Warren has learned to 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.

Total Liabilities and the Debt to Shareholders' Equity ratio

TOTAL LIABILITIES AND THE DEBT TO SHAREHOLDERS' EQUITY RATIO

Balance Sheet/             Debt to Shareholders' Equity Ratio
($ in millions)
Total Current Liabilities	$13,225
Long-Term Debt	3,277
Deferred Income Tax	1,890
Minority Interest	0
Other Liabilities	3,133
> Total Liabilities	$21,525

Total liabilities is the sum of all the liabilities of the company. It is an important number that can be used to give us the debt to shareholders' equity ratio, which, with slight modification, can be used to help us identify whether or not a business has a durable competitive advantage.

The debt to shareholders' equity ratio has historically been used to help us identify whether or not a company is using debt to finance its operations or equity (which includes retained earnings).       

-  The company with a durable competitive advantage will be using its earning power to finance its operations and therefore, in theory, should show a higher level of shareholders' equity and a lower level of total liabilities. 

-  The company without a competitive advantage will be using debt to finance its operations and, therefore, should show just the opposite, a lower level of shareholders' equity and a higher level of total liabilities.

The equation is: Debt to Shareholders' Equity Ratio = Total Liabilities / Shareholders' Equity.

The problem with using the debt to equity ratio as an identifier is that the economics of companies with a durable competitive advantage are so great that they don't need a large amount of equity/retained earnings on their balance sheets to get the job done; in some cases they don't need any. Because of their great earning power they will often spend their built-up equity/retained earnings on buying back their stock, which decreases their equity/retained earnings base. That in turn increases their debt to equity ratio, often to the point that their debt to equity ratio looks like that of a mediocre business---one without a durable competitive advantage.

Moody's, a Warren favorite, is an excellent example of this phenomenon. It has such great economics working in its favor that it doesn't need to maintain any shareholders' equity. It actually spent all of its shareholders' equity on buying back its shares. It literally has negative shareholders' equity. This means that its debt to shareholders' equity ratio looks more like that of GM---a company without a durable competitive advantage and a negative net worth---than, say, that of Coca-Cola, a company with a durable competitive advantage.

However, if we add back into Moody's shareholders' equity the value of all the treasury stock that Moody has acquired through stock buybacks, then Moody's debt to equity ratio drops down to .63, in line with Coke's treasury share-adjusted ratio of .51. GM still has a negative net worth, even with the addition of the value of its treasury shares, which are nonexistent because GM doesn't have the money to buy back its shares.

It is easy to see the contrast between companies with a durable competitive advantage and those without it when we look at the treasury share-adjusted debt to shareholders' equity ratio. Durable competitive advantage holder Procter & Gamble has an adjusted ratio of .71; Wrigley, meanwhile, has a ratio of .68---which means that for every dollar of shareholders' equity Wrigley has, it also has 68 cents in debt. Contrast P&G and Wrigley with Goodyear Tire, which has an adjusted ratio of 4.35, or Ford, which has an adjusted ratio of 38.0. This means that for every dollar of shareholders' equity that Ford has, it also has $38 in debt---which equates to $7.2 billion in shareholders' equity and $275 billion in debt.

With financial institutions like banks, the ratios, on average, tend to be much higher than those of their manufacturing cousins. Banks borrow tremendous amounts of money and then loan it all back out, making money on the spread between what they paid for the money and what they can loan it out for. This leads to an enormous amount of liabilities, which are offset by a tremendous amount of assets. On average, the big American money center banks have $10 in liabilities for every dollar of shareholders' equity they keep on their books. This is what Warren means when he says that banks are highly leveraged operations. There are exceptions though and one of them is M&T Bank, a longtime Warren favorite. M&T has a ratio of 7.7, which is reflective of its management's more conservative lending practices.

The simple rule here is that, unless we are looking at a financial institution, any time we see an adjusted debt to shareholders' equity ratio below .80 (the lower the better), there is a good chance that the company in question has the coveted durable competitive advantage we are looking for.

And finding what one is looking for is always a good thing, especially if one is looking to get rich.

LONG-TERM DEBT: Something that great companies don't have a lot of

LONG-TERM DEBT: SOMETHING THAT GREAT COMPANIES

DON'T HAVE A LOT OF

Balance Sheet/Liabilities
($ in millions)
Total Current Liabilities	$13,225
->Long-Term Debt	3,277
Deferred Income Tax	1,890
Minority Interest	0
Other Liabilities	3,133
Total Liabilities	$21,525

Long-term debt means debt that matures any time out past a year. On the balance sheet it comes under the heading of long-term liabilities. If the debt comes due within the year, it is short-term debt and is placed with the company's current liabilities. In Warren's search for the excellent business with a long-term competitive advantage, the amount of long-term debt a company carries on its books tells him a lot about the economic nature of the business.

Warren has learned that companies that have a durable competitive advantage often carry little or no long-term debt on their balance sheets. This is because these companies are so profitable that they are self-financing when they need to expand the business or make acquisitions, so there is never a need to borrow large sums of money.

One of the ways to help us identify the exceptional business, then, is to check how much long-term debt it is carrying on its balance sheet. We are not just interested in the current year; we want to look at the long-term debt load that the company has been carrying for the last ten years. If there have been ten years of operations with little or no long-term debt on the company's balance sheet it is a good bet that the company has some kind of strong competitive advantage working in its favor.

Warren's historic purchases indicate that on any given year the company should have sufficient yearly net earnings to pay off all of its long-term debt within a three-or four-year earnings period. Long-term competitive advantage holders Coca-Cola and Moody's could pay off all their long-term debt in a single year; and Wrigley and The Washington Post companies can do it in two.

But companies like GM or Ford, both in the highly competitive auto industry, could spend every dime of net profit they have earned in the last ten years and still not pay off the massive amount of long-term debt they carry on their balance sheets.

The bottom line here is that companies that have enough earning power to pay off their long-term debt in under three or four years are good candidates in our search for the excellent business with a long-term competitive advantage.

But please note: Because these companies are so profitable and carrying little or no debt, they are often the targets of leveraged buyouts. This is where the buyer borrows huge amounts of money against the cash flow of the company to finance the purchase. After the leveraged buyout the business is then saddled with large amounts of debt. This was the case with the RJR/Nabisco buyout in the late 1980s.

If all else indicates that the business in question is a company with a durable competitive advantage, but it has a ton of debt on its balance sheet, a leveraged buyout may have created the debt. In cases like these the company's bonds are often the better bet, in that the company's earning power will be focused on paying off the debt and not growing the company.

The rule here is simple: Little or No Long-Term Debt Often Means a Good Long-Term Bet.

Debt test of Warren Buffett

3 Quick Tests for a Business with a long-term Durable Competitive Advantage:

1.   Earning Test

2.   Return (Profit) Test and

3.   Debt test.

3. Debt Test

"One of the things you will find---which is interesting and people don't think of it enough---with most businesses and with most individuals, is life tends to snap you at your weakest link. The two biggest weak links in my  experience: I've seen more people fail because of liquor and leverage---leverage being borrowed money."

                                      Warren Buffett

   

     INTEREST EXPENSE: WHAT WARREN DOESN'T WANT

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

Interest Expense is the entry for the interest paid out, during the quarter or year, on the debt the company carries on its balance sheet as a liability. While it is possible for a company to be earning more in interest than it is paying out, as with a bank, the vast majority of manufacturing and retail  businesses pay out far more in interest than they earn.

This is called a financial cost, not an operating cost, and it is isolated out on its own, because it is not tied to any production or sales process. Instead, interest is reflective of the total debt that the company is carrying on its books. The more debt the company has, the more interest it has to pay.

Companies with high interest payments relative to operating income tend to be one of two types: 

• a company that is in a fiercely competitive industry, where large capital expenditures are required for it to stay competitive, or 
• a company with excellent business economics that acquired the debt when the company was bought in a leveraged buyout.

What Warren has figured out is that companies with a durable competitive advantage often carry little or no interest expense. Long-term competitive advantage holder Procter & Gamble has to pay a mere 8 % of its operating income out in interest costs; the Wrigley Co. has to pay an average 7%; contrast those two companies with Goodyear, which is in the highly competitive and capital-intensive tire business. Goodyear has to pay, on average, 49% of its operating income out in interest payments.

Even in highly competitive businesses like the airline industry, the amount of the operating income paid out in interest can be used to identify companies with a competitive advantage. The consistently profitable Southwest Airlines pays just 9% of operating income in interest payments, while its in-and-out-of-bankruptcy competitor United Airlines pays 61% of its operating income out in interest payments. Southwest's other troubled competitor, American Airlines, pays a whopping 92% of its operating income out in interest payments.

As a rule, Warren's favorite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income. But be aware that the percentage of interest payments to operating income varies greatly from industry to industry. As an example: Wells Fargo, a bank in which Warren owns a 14% stake, pays out approximately 30% of its operating income in interest payments, which seems high compared with Coke's, but actually makes the bank, out of America's top five, the one with the lowest and most attractive ratio. Wells Fargo is also the only one with a AAA rating from Standard & Poor's.

The ratio of interest payments to operating income can also be very informative as to the level of economic danger that a company is in. Take the investment banking business, which on average makes interest payments in the neighborhood of 70% of its operating income. A careful eye would have picked up the fact that in 2006 Bear Stearns reported that it was paying out 70% of its operating income in interest payments, but that by the quarter that ended in November 2007, its percentage of interest payments to operating income had jumped to 230%. This means that it had to dip into its shareholders' equity to make up the difference. In a highly leveraged operation like Bear Stearns, that spelled disaster. By March of 2008 the once mighty Bear Stearns, whose shares had traded as high as $170 the year before, was being forced to merge with JP Morgan Chase & Co. for a mere $10 a share.

The rule here is real simple: In any given industry the company with the lowest ratio of interest payments to operating income is usually the company most likely to have the competitive advantage. In Warren's world, investing in the company with a durable competitive advantage is the only way to ensure that we are going to get rich over the long-term.