Gross Profit Margin: Key numbers for Warren in his search for long-term gold.

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

1.   Earning Test

2.   Return (Profit) Test and

3.   Debt test.

2. Return (Profit) Test

GROSS PROFIT/GROSS PROFIT MARGIN: KEY NUMBERS FOR WARREN IN His SEARCH FOR LONG-TERM GOLD

  

Income Statement
($ in millions)
-> Revenue	$10,000
Cost of Goods Sold	3,000
-> Gross Profit	$7,000

    Gross Profit $7,000 / Revenue $10,000 = Gross Profit Margin 70%

Now if we subtract from the company's total revenue the amount reported as its Cost of Goods Sold, we get the company's reported Gross Profit. An example: total revenue of $10 million less cost of goods sold of $3 million equals a gross profit of $7 million.

        Gross profit is how much money the company made off of total revenue after subtracting the costs of the raw goods and the labor used to make the goods. It doesn't include such categories as sales and administrative costs, depreciation, and the interest costs of running the business.

By itself, gross profit tells us very little, but we can use this number to calculate the company's gross profit margin, which can tell us a lot about the economic nature of the company.

The equation for determining gross profit margin is:

Gross Profit / Total Revenues = Gross Profit Margin

Warren's perspective is to look for companies that have some kind of durable competitive advantage---businesses that he can profit from over the long run. What he has found is that companies that have excellent long-term economics working in their favor tend to have consistently higher gross profit margins than those that don't.

Let me show you:

The gross profit margins of companies that Warren has already identified as having a durable competitive advantage include: Coca-Cola, which shows a consistent gross profit margin of 60% or better; the bond rating company Moody's, 73%; the Burlington Northern Santa Fe Railway, 61%; and the very chewable Wrigley Co., 51%.

Contrast these excellent businesses with several companies we know that have poor long-term economics, such as the in-and-out-of-bankruptcy United Airlines, which shows a gross profit margin of 14%; troubled auto maker General Motors, which comes in at a weak 21%; the once troubled, but now profitable U.S. Steel, at a not-so-strong 17%; and Goodyear Tyre---which runs in any weather, but in a bad economy is stuck at a not-very-impressive 20%.

In the tech world---a field Warren stays away from because he doesn't understand it---Microsoft shows a consistent gross profit margin of 79%, while Apple Inc. comes in at 33%. These percentages indicate that Microsoft produces better economics selling operating systems and software than Apple does selling hardware and services.

What creates a high gross profit margin is the company's durable competitive advantage, which allows it the freedom to price the products and services it sells well in excess of its cost of goods sold. Without a competitive advantage, companies have to compete by lowering the price of the product or service they are selling. That drop, of course, lowers their profit margins and therefore their profitability.

As a very general rule (and there are exceptions): Companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage. Companies with gross profit margins below 40% tend to be companies in highly competitive industries, where competition is hurting overall profit margins (there are exceptions here, too). Any gross profit margin of 20% and below is usually a good indicator of a fiercely competitive industry, where no one company can create a sustainable competitive advantage over the competition. And a company in a fiercely competitive industry, without some kind of competitive advantage working in its favor, is never going to make us rich over the long run.

While the gross profit margin test is not fail-safe, it is one of the early indicators that the company in question has some kind of consistent durable competitive advantage. Warren strongly emphasizes the word "durable," and to be on the safe side we should track the annual gross profit margins for the last ten years to ensure that the "consistency" is there. Warren knows that when we look for companies with a durable competitive advantage, "consistency" is the name of the game.

Now there are a number of ways that a company with a high gross profit margin can go astray and be stripped of its long-term competitive advantage. One of these is high research costs, another is high selling and administrative costs, and a third is high interest costs on debt. Any one of these three costs can destroy the long-term economics of the business. These are called operating expenses, and they are the thorn in the side of every business.

Total Assets and the Return on Total Assets

TOTAL ASSETS AND THE RETURN ON TOTAL ASSETS

  

Balance Sheet/Assets
($ in millions)
Total Current Assets	$12,005
Property/Plant/Equipment	8,493
Goodwill, Net	4,246
Intangibles, Net	7,863
Long-Term Investments	7,777
Other Long-Term Assets	2,675
Total Assets	$43,059

Add current assets to long-term assets, and we get the company's total assets. Its total assets will match its total liabilities, plus shareholders' equity. They balance with each other, which is why it is called a balance sheet.

Total assets are important in determining just how efficient the company is in putting its assets to use. To measure the company's efficiency, analysts have come up with the return on asset ratio, which is found by dividing net earnings by total assets.

Capital, however, always presents a barrier to entry into any industry, and one of the things that helps make a company's competitive advantage durable is the cost of the assets one needs to get into the game. Coca-Cola has $43 billion in assets and a return on assets of 12%; Procter & Gamble has $143 billion in assets and a return on assets of 7%; and Altria Group, Inc., has $52 billion in assets and a return on assets of 24%. But a company like Moody's, which has $1.7 billion in assets, shows a 43% return on assets.

While many analysts argue that the higher the return on assets the better, Warren has discovered that really high returns on assets may indicate vulnerability in the durability of the company's competitive advantage. Raising $43 billion to take on Coca-Cola is an impossible task---it's not going to happen. But raising $1.7 billion to take on Moody's is within the realm of possibility. While Moody's underlying economics is far superior to Coca-Cola's, the durability of Moody's competitive advantage is far weaker because of the lower cost of entry into its business.

The lesson here is that sometimes more can actually mean less over the long-term.

PER-SHARE EARNINGS: How Warren tells the winners from the losers

PER-SHARE EARNINGS: How WARREN TELLS THE WINNERS FROM THE LOSERS

Per-share earnings are the net earnings of the company on a per-share basis for the time period in question. This is a big number in the world of investing because, as a rule, the more a company earns per share the higher its stock price is. To determine the company's per-share earnings we take the amount of net income the company earned and divide it by the number of shares it has outstanding. As an example: If a company had net earnings of $10 million for the year, and it has one million shares outstanding, it would have per-share earnings for the year of $10 a share.

While no one yearly per-share figure can be used to identify a company with a durable competitive advantage, a per-share earnings figure for a ten-year period can give us a very clear picture of whether the company has a long-term competitive advantage working in its favor. What Warren looks for is a per-share earning picture over a ten-year period that shows consistency and an upward trend.

 Something that looks like this:

08	$2.95
07	$2.68
06	$2.37
05	$2.17
04	$2.06
03	$1.95
02	$1.65
01	$1.60
00	$1.48
99	$1.30
98	$1.42

This shows Warren that the company has consistent earnings with a long-term upward trend---an excellent sign that the company in question has some kind of long-term competitive advantage working in its favor. Consistent earnings are usually a sign that the company is selling a product or mix of products that don't need to go through the expensive process of change. The upward trend in earnings means that the company's economics are strong enough to allow it either to make the expenditures to increase market share through advertising or expansion, or to use financial engineering like stock buybacks.

The companies that Warren stays away from have an erratic earnings picture that looks like this:

                       

08	$2.50
07	$(0.45) loss
06	$3.89
05	$(6.05) loss
04	$6.39
03	$5.03
02	$3.35
01	$1.77
00	$6.68
99	$8.53
98	$5.24

This shows a downward trend, punctuated by losses, which tells Warren that this company is in a fiercely competitive industry prone to booms and busts. The booms show up when demand is greater than supply, but when demand is great, the company increases production to meet demand, which increases costs and eventually leads to an excess of supply in the industry. Excess leads to falling prices, which means that the company loses money until the next boom comes along. There are thousands of companies like this, and the wild price swings in shares, caused by each company's erratic earnings, create the illusion of buying opportunities for traditional value investors. But what they are really buying is a long, slow boat ride to investor nowhere.

NET EARNINGS: What Warren is looking for

NET EARNINGS: WHAT WARREN Is LOOKING FOR

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
Gain (Loss) Sale Assets	1,275
Other	225
Income Before Tax	1,500
Income Taxes Paid	525
Net Earnings	$975

After all the expenses and taxes have been deducted from a company's revenue, we get the company's net earnings. This is where we find out how much money the company made after it paid income taxes. There are a couple of concepts that Warren uses when he looks at this number that help him determine whether the company has a durable competitive advantage, so why don't we start there.

First on Warren's list is whether or not the net earnings are showing a historical upward trend. A single year's entry for net earnings is worthless to Warren; he is interested in whether or not there is consistency in the earnings picture and whether the long-term trend is upward---both of which can be equated to "durability" of the competitive advantage. For Warren the ride doesn't have to be smooth, but he is after a historical upward trend.

But note: Because of share repurchase programs it is possible that a company's historical net earnings trend may be different from its historical per-share earnings trend. Share repurchase programs will increase per-share earnings by decreasing the number of shares outstanding. If a company reduces the number of shares outstanding, it will decrease the number of shares being used to divide the company's net earnings, which in turn increases per-share earnings even though actual net earnings haven't increased. In extreme examples the company's share repurchase program can even cause an increase in per-share earnings, while the company is experiencing an actual decrease in net earnings.

Though most financial analysis focuses on a company's

per-share earnings, Warren looks at the business's net earnings to see what is actually going on.

What he has learned is that companies with a durable competitive advantage will report a higher percentage of net earnings to total revenues than their competitors will. Warren has said that given the choice between owning a company that is earning $2 billion on $10 billion in total revenue, or a company earning $5 billion on $100 billion in total revenue, he would choose the company earning the $2 billion. This is because the company with $2 billion in net earnings is earning 20% on total revenues, while the company earning $5 billion is earning only 5% on total revenues.

So, while the total revenue number alone tells us very little about the economics of the business, its ratio to net earnings can tell us a lot about the economics of the business compared with other businesses.

A fantastic business like Coca-Cola earns 21% on total revenues, and the amazing Moody's earns 31 %, which reflects these companies' superior underlying business economics. But a company like Southwest Airlines earns a meager 7%, which reflects the highly competitive nature of the airline business, in which no one airline holds a long-term competitive advantage over its peers. In contrast, General Motors, in even a great year---when it isn't losing money---earns only 3% on total revenue. This is indicative of the lousy economics inherent in the super-competitive auto industry.

A simple rule (and there are exceptions) is that if a company is showing a net earnings history of more than 20% on total revenues, there is a real good chance that it is benefiting from some kind of long-term competitive advantage. Likewise, if a company is consistently showing net earnings under 10% on total revenues it is---more likely than not---in a highly competitive business in which no one company holds a durable competitive advantage. This of course leaves an enormous gray area of companies that earn between 10% and 20% on total revenue, which is just packed with businesses ripe for mining long-term investment gold that no one has yet discovered.

One of the exceptions to this rule is banks and financial companies, where an abnormally high ratio of net earnings to total revenues usually means a slacking-off in the risk management department. While the numbers look enticing, they actually indicate an acceptance of greater risk for easier money, which in the game of lending money is usually a recipe for making quick money at the cost of long-term disaster. And having financial disasters is not how one gets rich.

The Income Statement: The Earning Test

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

1.   Earning Test

2.   Return (Profit) Test and

3.   Debt test.

1.       Earning Test

WHERE WARREN STARTS: THE INCOME STATEMENT

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
Gain (Loss) Sale Assets	1,275
Other	225
Income Before Tax	1,500
Income Taxes Paid	525
Net Earnings	$975

In his search for the magic company with a durable competitive advantage, Warren always starts with the firm's income statement. Income statements tell the investor the results of the company's operations for a set period of time. Traditionally, they are reported for each three-month period and at the end of the year. Income statements are always labeled for the time period they cover-such as January 1, 2007, to December 31, 2007.

An income statement has three basic components: First, there is the revenue of the business. Then there is the firm's expenses, which are subtracted from the firm's revenue and tell us whether the company earned a profit or had a loss. Sounds simple, doesn't it? It is.

In the early days of stock analysis the leading analysts of the time, such as Warren's mentor Benjamin Graham, focused purely on whether or not the firm produced a profit, and gave little or no attention to the long-term viability of the source of the company's earnings. As we discussed earlier, Graham didn't care if the company was an exceptional business with great economics working in its favor or if it was one of the thousands of mediocre businesses struggling to get by. Graham would buy into a lousy business in a heartbeat if he thought he could get it cheaply enough.

Part of Warren's insight was to divide the world of businesses into two different groups: 

• First, there were the companies that had a long-term durable competitive advantage over their competitors. These were the businesses which, if he could buy them at a fair or better price, would make him superrich if he held them long enough. 
• The other group was all the mediocre businesses that struggled year after year in a competitive market, which made them poor long-term investments.

In Warren's search for one of these amazing businesses, he realized that the individual components of a company's income statement could tell him whether or not the company possessed the super-wealth-creating, long-term durable competitive advantage that he so coveted. Not just whether or not the company made money. But what kind of margins it had, whether it needed to spend a lot on research and development to keep its competitive advantage alive, and whether it needed to use a lot of leverage to make money. These factors comprise the kind of information he mines from the income statement to learn the nature of a company's economic engine. To Warren, the source of the earnings is always more important than the earnings themselves.

For the next fifty chapters we are going to focus on the individual components of a company's financial statement and what Warren is searching for that will tell him if this is the kind of business that will send him into poverty, or the golden business with a long-term durable competitive advantage that will continue to make him one of the richest people in the world.