WHAT BUFFETT LOOKS FOR – in the BALANCE SHEET
Further to my previous post regarding Buffett’s interrogation of the Income Statement, we can now look at what he looks for in the Balance Sheet in his quest to Identify and Value companies with Durable Competitive Advantage (DCA).
Before we go into detail, it’s my personal opinion that this is where the degree of emphasis that Buffett placed on company valuation differed, to a certain extent, from that of Ben Graham, his mentor.
A fair degree of Graham’s emphasis was placed on the book value/cash value per share of the business, as determined from within its Balance Sheet. If this was at least 50% higher than the current share price then Graham saw an undervalued company and would usually invest in it.
On the other hand, Buffett’s emphasis was directed more towards the Income Statement because he was after evidence of a steady increase in Net Income and what this ratio was with regards to a company’s Shareholder’s Equity.
In addition he was also interested in the value of the Pretax Earnings, from within the Income Statement, because this was a major contributor to his calculation of the “Equity Bond” and formed the equivalent of a bond’s “Coupon”. The difference between a conventional bond’s Coupon (which remains fixed) and Buffett’s “Coupon” was the fact that, for a company with DCA, the Pretax Earnings generally keep increasing, year after year, which increases the “Equity Bond’s” value, year after year.
So let’s see what Buffett Looks For .... firstly on the ASSETS side ....
CURRENT ASSETS.
These are listed in order of Liquidity. Also referred to as the “Working Assets” of a business because they contain the cycle of CASH, which buys INVENTORY, which is sold to vendors and becomes ACCOUNTS RECEIVABLE, which is collected and turned back into CASH, so completing the cycle over and over again, which is how a business makes Money.
Cash & Short Term Investments :- Buffett looks for a past history of the ongoing build up of Cash & Marketable Securities and little or no Debt. It’s preferable to see Cash created by ongoing business operations than by one-time events such as a sale of an asset.
Inventory :- DCA Companies sell products that never change and, as a result, they don’t become obsolete. Therefore look for both Inventory and Net Earnings on a corresponding Rise. This shows that such a company is finding profitable ways to increase Sales. And an increase in Sales requires an increase in Inventory so that Orders can be filled on time.
The “Current Ratio” (C.R.) :- Generally the higher the ratio Current Assets/Current Liabilities is, the better as this implies the company can meet its short term debt obligations. If the Current Ratio (C.R.) <1 it usually implies that the company may have problems meeting short term debt etc.
However, DCA companies often have their C.R. < 1 because their Earning Power is so strong that they can generally cover their Current Liabilities. And because of their outstanding Earning Power they can pay great dividends and buy back their own stock, which can reduce their Cash Reserves and bring their C.R. below 1.
FIXED ASSETS.
Property, Plant & Equipment :- Buffett wants as little as possible of this item on the Balance Sheet. DCA companies generally don’t need to constantly upgrade plant & equipment to stay competitive. It gets replaced when it wears out. The same can’t be said for the likes of GM or F which have to constantly re-tool to produce new products.
Long Term Investments (L.T.I.) :- This Asset is carried on the books at Cost or Market Price, whichever is LOWER. It cannot be at a price greater than Cost even if the investments have appreciated in value. Therefore there could be a valuable Asset on the books at a Low Valuation.
Long Term Investments should be as LARGE as possible but these investments should, preferably, be in DCA companies.
Return on Total Assets (ROA) :- ROA = Net Earnings/Total Assets.
Capital presents a barrier to entry into any industry. Coca Cola has $43bil. in Assets with an ROA of 12%.
Proctor & Gamble has $143bil. in Assets with an ROA of 7%.
But Moody’s, a DCA company, has only $1.7bil. in Assets with a relatively high ROA of 43%.
To take on Coca Cola or P&G with their Asset size is a near impossible task.
However, Moody’s is far more vulnerable at only $1.7bil.
Some may say that the higher the ROA the better.
But a high ROA may indicate Vulnerability if its Total Assets are Low.
CURRENT LIABILITIES.
Short Term Debt :- Buffett stays away from companies that are bigger borrowers of Short Term money than of Long Term money. Borrowers of Short Term money can be at RISK due to sudden moves in the Credit Markets.
Long Term Debt Due :- Beware of companies that include “Long Term Debt Due” under “Current Liabilities” as they may want to give the impression of having more Shorter Term debt than they actually have.
Also DCA companies require little, or no, Long Term Debt which means they’ll have little, or no, Long Term Debt Due.
TOTAL LIABILITIES.
Long Term Debt (L.T.D.) :- Should be as LOW as possible because DCA companies are so profitable they are self-financing. Buffett looks for companies whose Annual Net Earnings could pay off L.T.D. within a 3 to 4 year Earnings Period, or Less.
Debt to Shareholders’ Equity Ratio :- This Ratio = TOTAL LIABILITIES/SHAREHOLDERS’ EQUITY.
DCA companies can show HIGH Debt/Equity ratios because they have used their Retained Earnings to Buy Back their own stock.
Therefore ADD BACK the VALUE of TREASURY STOCKS to a company’s Shareholders’ Equity.
This Adjusted TOTAL LIABILITIES/SHAREHOLDERS’ EQUITY Ratio should be <0.8, or Lower.
Preferred Stock :- There should, preferably, be NO Preferred Stock as they require paid dividends. These dividends are not deductible from Pretax Income, therefore it makes Preferred Stock expensive borrowed money.
Retained Earnings :- These should increase at an Annual rate. A percentage >7% per annum is often seen in DCA companies.
Buffett invests Retained Earnings, preferably, in DCA companies.
Treasury Stock :- DCA companies usually have this on their Balance Sheets, and they buy them on an ongoing basis. They can either be CANCELLED or RETAINED for re-issue at a later date.
RETURN ON SHAREHOLDERS’ EQUITY (R.O.E.)
Shareholders’ Equity (S.E.) = Total Assets – Total Liabilities.
Return on Shareholders’ Equity = Net Income/S.E.
The higher this Ratio is the better. Look for R.O.E. > 25%.
Sometimes VERY PROFITABLE companies don’t need to Retain Earnings so they pay them all out to Shareholders. Therefore their S.E. can be Negative.
If a company shows a Long History of Strong, Positive Net Earnings AND Negative Shareholders' Equity, it’s probably a DCA company.
If a company shows BOTH a Long History of Negative Net Earnings as well as Negative Shareholders' Equity, it’s NOT a DCA company. |
