WHAT BUFFETT LOOKS FOR – in the CASH FLOW STATEMENT
Most companies use the ACCRUAL Method of Accounting which allows them to book SALES on Credit in the Income Statement. However, to keep a separate check of the Actual CASH that moves in and out of a business, accountants created the CASH FLOW STATEMENT (CFS).
For those who may need a refresher or are not that familiar with the CFS, it’s made up of 3 sections ...
Cash from OPERATING ACTIVITIES : Includes, primarily, Net Income, Depreciation, Amortization
Cash from INVESTING OPERATIONS : Includes Capital Expenditures, Other Investing Cash Items
Cash from FINANCING ACTIVITIES : Includes Payment for Dividends, Buying or Selling Company Stock
So let’s see what Warren Buffett looks for in the Cash Flow Statement to help him determine if the company in question has a Durable Competitive Advantage ....
(A) Cash from INVESTING OPERATIONS :- DCA companies usually use smaller portions of their Earnings for CAPITAL EXPENDITURES for Continuing Operations than do those without DCA.
Warren adds up a company’s Total Capital Expenditures for a 10 Year period and compares that to the company’s Total Net Earnings for the same 10 Year period. This gives a good long term perspective as to what’s going on with the business.
DCA companies such as Coca Cola use only 19% of Net Earnings for Capital Expenditures. Proctor & Gamble uses 28%, Pepsico uses 36% etc..
However, GM uses 444% and Goodyear used 950%. That extra money had to come from somewhere. This would usually have been from Bank Loans and/or Selling lots of New Debt to the public. This is not always a good thing as Debt just adds Interest Expense which reduces Bottom Line.
Buffett looks for a Capital Expenditure/Net Earnings ratio of <50%.
If the ratio is Consistently <25% then it’s very likely to be a DCA company.
(B) Cash from FINANCING ACTIVITIES :-A DCA company usually makes a LOT of money. The company can pay it out as Dividends or use it to Buy Back its Shares.
Buffett prefers to see the money used to BUY BACK SHARES because this ...
(i) REDUCES the Number of Outstanding Shares which INCREASES the remaining Shareholder’s Interest in the company, and ...
(ii) INCREASES the Per-Share Earnings of the company which eventually BOOSTS the STOCK’S PRICE.
In this section of the CFS look for the item “Issuance (Retirement) of Stock, Net”.
Buffett looks for this to be a regular Negative Value, or (Retirement), which indicates a NET Buying of its shares compared to a Net Issuance of more shares. |
