text: Table of Contents
  - Introduction
  - Common terms
  - Income Statement
  - Balance Sheet
  - Cash Flow Statement
  - How to value a DCA Company
  - Notes from “Warren Buffett and the Interpretation of Financial Statements”
  - Notes from The Buffettology Workbook
  - Investing terminology and definitions
  - TODO
  - Resources used in creating this page
  - Websites/Resources
  - Notes from “The Buffettology Workbook”
  - Buffettology Worksheet
  - Buffettology investing resources
  - CAGR calculators
  - Good Buffett quotes
  - Summary
  For the last few weeks I’ve been studying Buffettology as a way of investing, and as a result of reading several “Buffettology” books, this page contains all of my notes on reading financial statements and investing in stocks using the Buffettology philosophy. The notes primarily come from theses books:
  - Warren Buffett and the Interpretation of Financial Statements (abbreviated below as WBaIFS)
  - The Buffettology Workbook
  - The New Buffettology
  - The Warren Buffett Way
  Note that I have a related Warren Buffett Way cheat sheet (which is surprisingly different than this cheat sheet which is based on the Buffettology books), and at some point I’ll combine the two.
  Introduction
  A great summary of Buffetology is that you should try to find companies with a durable competitive advantage; wait for a buying opportunity that Mr. Market presents to you; buy the company’s stock when you have a high degree of certainty that you can achieve a compounded annual growth rate of 15% or more.
  In a related note, as one of the quotes below states, you should “Act as though you have a ‘lifetime decision card’ with just twenty punches on it.” This means that you shouldn’t expect to find dozens of companies like this every year, you might only find twenty in your lifetime, and you need to be ready to pounce when the opportunity presents itself.Back to top
  Common terms
  Note that in the notes below the acronym DCA is used a lot, and it stands for Durable Competitive Advantage.Back to top
  Income StatementBack to top
  Balance Sheet
  The following table covers items that are found on a Balance Sheet. One thing to know:
  Assets - Liabilities = Net Worth (or Shareholder’s Equity)
  Discussion:
  - ROE = Net Earnings / Shareholders’ Equity
  - DCAs have higher than average ROE
  - Ex: Coca-Cola=30%, Wrigley=24, Hersheys=33, Pepsi=34 (44 this year)
  - Some companies are so profitable, they don’t need to retain any earnings, so they pay them out to shareholders as dividends; in this case, shareholder equity can be a negative number. If the company has a strong history of large net earnings but negative shareholders’ equity it probably has a DCA.
  Leverage discussion:
  - Leverage is the use of debt to increase business earnings. The company borrows $100M at 7% and puts it to work, hoping to make 12%.
  - That means it earned 5% in excess of its capital costs. Adds $5M to bottom line, which increases earnings and ROE.
  - Problem is, it can appear that the company has a DCA (because it inflates ROE), when in fact it’s really just using debt.
  - Wall Street banks are notorious for this practice, borrowing $100B at 6% and lending it at 7%.
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  Cash Flow Statement
  - Since the Accrual Method lets sales that were made on credit to be booked as revenue, it becomes necessary to keep track of actual cash flows in and out of the company.
  - Can have a lot of sales on credit and not have any cash flowing in.
  - This statement tells you if there is positive or negative cash flow.
  - Like the Income Statement, the Cash Flow Statement always covers a set period of time.
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  How to value a DCA Company
  TODO
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  Notes from “Warren Buffett and the Interpretation of Financial Statements”
  These are my notes from the book, Warren Buffett and the Interpretation of Financial Statements. There are a lot of good things in this book, as evidenced by the financial statement notes above, but these are other good notes from that book.
  - “Durable Competitive Advantage” is mentioned about 100 times.
  - Consumer Monopoly vs Commodity is also stressed a lot.
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  Notes from The Buffettology Workbook
  The best information from the book, The Buffettology Workbook:
  - Buy “Consumer Monopolies,” don’t buy Commodity businesses
  - Consumer Monopolies:
  - Like a toll bridge, you have to buy it from them
  - Would it be possible to compete with this company?
  - Quality and uniqueness are most important factors to buyers
  - High ROE
  - Strong brand name product or key service
  - If the company is a monopoly you can project the future price of the stock using the company’s per-share annual growth rate
  - “Sick” Commodities:
  - Low profit margin
  - Low ROE
  - Competitive — multiple producers of the product
  - Erratic profits
  - May have to keep investing capital in plants/facilities to stay competitive
  - For a company to make shareholders rich over the long run:
  - It must have high ROE
  - Must be able to retain earnings and not have to spend it all on maintaining current operations
  - A 10-year summary of EPS will tell a lot about a company
  - Look for strong, growing EPS (not wild fluctuations)
  - Company earnings:
  - If the company earned $5/share and you own 100 shares, you earned $500
  - If you paid $25/share and it earned $5/share, your initial rate of return is 20%
  - The price you pay determines your return (it’s the denominator in that equation)
  - To grow EPS, management must employ retained earnings intelligently
  - Over time increased EPS will increase the stock’s price
  - All investments compete for your money
  - Think of the Treasury Bond as competing with the return paid on other investments
  - Think of a share of stock as a type of equity/bond in which the EPS can be thought of as the equity/bond yield
  - But, the yield varies each year; if it continuously increases that’s a good thing
  - If you can’t confidently predict the earnings for the company for ten years, look at other investment opportunities
  - After you estimate future earnings, you can estimate the future stock price using the average P/E ratio for the last ten years
  - The coupon/bond analogy is important to the process
  - “If I pay X for a share of stock, given the economic realities of the business, what is my expected annual compounding rate of return going to be in ten years?”
  - In this way you never have to worry about what price Mr. Market has been on the stock each day
  - Companies buying back their stock:
  - Increases EPS
  - The pie is the same size, but the slices are larger. (Ex: Company with three owners; company buys out one owner, retires shares. The business earnings are still the same, but now they’re shared by only two owners, i.e., 50% each rather than 33%.
  - Some share repurchases can mask poor performance; look at raw earnings in addition to EPS
  - Companies that do a good job of allocating retained earnings will make their shareholders more money
  - Look for a history of smart management
  - Consumer monopolies naturally do a better job of allocating retained earnings
  - Commodities are at a disadvantage because they have low margins and need to continually invest in equipment to stay in business (Intel, GE)
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  Investing terminology and definitions
  More:
  - EPS - basic vs diluted
  - Free cash flow
  - Operating cash flow
  - Adjusted (operating) earnings
  - Normalized basic earnings
  - Diluted earnings
  - ROA v ROE v ROI — when is each appropriate?
  TODO
  - What website(s) can help me find good Buffettology candidates?
  - What website(s) can help me compare a company like Ford to its competitors?
  - How should you read a financial statement? In what order? Early red flags to look for?
  - When you get a new idea, start with Fastgraphs
  - Create a Buffettology worksheet (so I can work through the evaluation process)
  Resources used in creating this page
  - Warren Buffett and the Interpretation of Financial Statements
  - The Buffettology Workbook
  - The New Buffettology
  - The Intelligent Investor (by Benjamin Graham)
  - Charlie Munger: The Complete Investor
  - The Neatest Little Guide to Stock Market Investing
  - The Warren Buffett Way
  Websites/Resources
  - Barchart
  - Buy/sell recommendations, including Top 100 Stocks
  - Trading signals
  - Earnings reports in the next seven days
  - Finviz
  - Lots of ratios and data for right now; analysts recommendations; links to news; insider transactions
  - Good screener
  - In general, a lot of data in a compact format
  - Click “financial highlights” to see Reuters data
  - Morningstar
  - Picker/screener shows stocks they think are undervalued (Price vs Fair Value)
  - Has a good summary page for each stock (but it doesn’t print well)
  - Financial data goes back 5-10 years
  - Lots of “moat” references
  - Motley Fool
  - Buy/Sell recommendations
  - CEO approval rating
  - Reuters (via Finviz)
  - Possibly the best ratio information
  - Yahoo
  - Good information for the current year
  Notes from “The Buffettology Workbook”
  The following notes come from The Buffettology Workbook and The New Buffettology (which is actually more detailed than the workbook).
  - Buffett separates companies into two types:
  - Commodities — don’t buy
  - Consumer Monopolies — buy these
  - Commodities
  - Low profit margins w/ low inventory turnover
  - Low returns on shareholder equity (low ROE)
  - Erratic profits
  - No brand loyalty
  - Multiple producers of the product(s)
  - Profitability depends on management’s ability to use tangible assets (Intel, GM, Ford)
  - Consumer Monopolies
  - A type of “toll bridge” business; if you want the product/service you have to get it from this company
  - Can you create a competing business even if you don’t care about losing money?
  - Sells a product where quality and uniqueness are the most important buying factors
  - Don’t forget that they can still have ups and downs
  - Consumer Monopoly keys
  - A brand name product or service
  - Usually has a high ROE
  - Usually conservatively financed (little debt, or debt can easily be paid off from earnings)
  - Must be able to retain its earnings and not have to spend earnings on maintaining current operations
  - Four types of consumer monopolies
  - Products are used up quickly, must be replenished, brand name appeal, merchants must carry
  - Communication businesses that provide a repetitive service that manufacturers must advertise through
  - Provide repetitive services that are consistently needed
  - Retail stores that have a quasi-monopoly (jewelry, furniture)
  - Four flavors of bad news:
  - Stock market correction or panic
  - Industry recession
  - Individual business calamity (VLKAY, current Facebook issues)
  - Structural changes
  - Note: In the following lines I refer to Steps 1-10, and the Buffett books refer to them as Calculations 1-10
  - Step 1
  - Look at a 10-year summary of EPS, it tells you a great deal
  - Look for a consistent upward trend, not wildly fluctuating earnings
  - Look for strong EPS history with a temporary setback in the last year (or so)
  - Step 2
  - Purpose: determine your initial rate of return
  - How to think: Look at the company’s earnings as being your earnings
  - If the company makes $5/share and you own 100 shares, think, “I made $500”
  - If you pay $25/share for a stock and it earns $5/share (EPS), you’re getting an Initial Rate of Return of 20% (5/25*100)
  - The price you pay determines your initial rate of return:
  - 5/25=20%, but 5/50=10%
  - Step 3
  - Purpose: Determine the per-share growth rate
  - Goal: Is management growing EPS over time?
  - Look at the last 10 years of EPS. Separate it into (a) total 10 years, and (b) just the last five years. Are earnings growing? The last five years should be higher than the total ten years.
  - Example: 12% over ten years, and 16.6% over the last five years
  - Assuming things look good, ask questions like these:
  - What were the business economics that helped this business be successful? Is the situation the same or different?
  - Is the company buying up its own stock?
  - Is it investing in other growing businesses?
  - KEY: Assuming company had a bad year, can the problem be solved?
  - Step 4
  - Purpose: Calculate the value relative to treasury bonds
  - Current treasury bond rates: Bloomberg, CNBC
  - Keys:
  - All investment opportunities compete with each other
  - The safest investment is a U.S. Treasury Bond
  - You gain a perspective by comparing a stock to the return of a treasury bond
  - Solution: Divide the EPS by the current return on treasury bonds
  - Example:
  - H&R Block’s EPS was 2.77 in 2000, t-bonds were paying 6%
  - 2.77 / 6% => $46.16
  - This means that if you bought Block at 46.16, you’d be getting the same rate of return as if you bought 46.16 worth of t-bonds
  - “Block has a value relative to t-bonds of 46.16 per share”
  - If Block is cheaper than 46.16 it may be worth buying (Buffett bought at $24/share)
  - With EPS of 2.77/share and a cost of 24/share, Block’s initial rate of return is 11.5% (2.77/24)
  - Note: Block grew EPS at 7.6% from 1990 to 2000, so you think, “11.5% initial rate of return plus 7.6% compounded yearly”
  - Step 5
  - Note: Steps 5 & 6 are different in the Workbook vs the small book
  - Purpose: Use EPS Annual Growth Rate to project a stock’s future value
  - A consumer monopoly has such consistent earnings that Buffett refers to them as an “equity/bond”
  - The EPS is the EquityBond’s yield
  - If ShareholderEquity is $10/share and NetEarnings are 2.50/share, the company is getting a return on its EquityBond of 25% (2.50/10.00) (ROE)
  - ShareholderEquity = Assets - Liabilities
  - Buffett doesn’t care what the company is earning next year, he cares what it will be earning in ten years
  - Another example follows
  - Note: Links to CAGR calculators:
  - Ex: Project Gannett’s future EPS for 2000
  - From 1980 to 1990 Gannett’s EPS grew at a compounded rate of 9.6%
  - EPS was 1.18 in 1990, assuming a constant 9.6%, it should be 2.95 in 2000
  - To calculate using CAGR, PV=1.18, N=10, I=9.6%
  - Summary: In theory, Gannett will have an EPS of 2.95 in 2000
  - Ex: Project the market price of Gannett’s stock in 2000
  - P/E from 1980-1990 varied from 11.5 to 23; average is 17.5
  - If EPS is 2.95 in 2000, its projected stock price is $51.62 (2.95*17.5)
  - Ex: Project the CAGR for Gannett between 1990-2000
  - In 1990 Gannett’s price was $14.80/share
  - CAGR: PV=14.80, FV=51.62, N=10
  - That yields a CAGR of 13.3%
  - Summary: If you buy their stock at 14.80 you get a CAGR of 13.3% for ten years
  - Actual result: Gannett traded for $53-70/share in 2000
  - Notes about that process
  - Buffett doesn’t carefully calculate a very specific future price for the stock
  - He doesn’t say, “I think the stock is worth X and it’s currently trading for X/2” as Graham did
  - He instead asks, “If I pay X for this stock, what CAGR can I reasonably expect to get in ten years?”
  - Don’t forget Mr. Market’s involvement: In the long term, the market will value the company to reflect the increase in the company’s net worth
  - Step 6
  - In the small book this is mostly a discussion of why a high ROE is important
  - Good discussion of Company A with ROE of 33% vs Company B with an ROE of 8%
  - The stock market goes down when interest rates go up, and the market goes up when interest rates go down
  - This is because stocks compete against t-bonds for your money
  - Also has an effect on bank loans and the cost of bonds that a company might issue
  - Excellent businesses that have a DCA and have a high ROE can still be a bargain buy even when it seems that their P/E is high
  - Step 7
  - Calculation #8
  - Calculation #9
  - Calculation #10
  Buffettology Worksheet
  - Does the company have a consumer monopoly? Describe it.
  - Do you understand how it works? (the product and/or the business)
  - What is the chance the company/product will become obsolete in the next 10-20 years? Explain why it won’t be.
  - Is the company a conglomerate? If so, is it made of commodities and monopolies? Dig in.
  - What is the EPS history?
  - Does it have a consistent ROE of 15% or greater?
  - Is it conservatively financed?
  - Is the company buying back its shares?
  - Is it free to raise prices with inflation?
  - Is the company’s stock price suffering from a market panic, a business recession, or an individual calamity that is curable?
  - What is the initial rate of the investment and its expected annual growth rate? How does it compare to investing in treasury bonds?
  - Initial rate of return: ____
  - Growth rate: ____
  - Rate of return on t-bonds: ____
  - Do the EquityBond calculations
  - Average annual growth rate for shareholder’s equity for the last ten years: ____
  - Average percentage paid out as a dividend: ____
  - Company’s shareholder equity per share in the current year: ____
  - Company’s average annual P/E ratio: ____
  - Project growth rate of shareholders’ equity over the next ten years: ____
  - Projected future trading price of the company’s stock: ____
  - Current trading price of the stock: ____
  - Project an annual CAGR using the historical annual EPS growth rate
  - EPS in 1990: ____
  - EPS in 2000: ____
  - Make the buy?
  Buffettology investing resources
  - Three ETFs that replicate Buffett’s strategy
  - Buffettology stock screeners
  CAGR calculatorsBack to top
  Good Buffett quotes
  - Never invest in a business you don’t understand
  - Forget about the stock market (buy companies)
  - Lethargy, bordering on sloth, should remain the cornerstone of an investment style
  - Act as though you have a “lifetime decision card” with just twenty punches on it
  - Don’t take yearly results seriously, focus on 4-5 year averages
  - The price you pay ultimately determines your annual compounding rate of return
  - You don’t need to know someone’s exact weight to know he’s fat (Benjamin Graham)
  Summary
  I hope to add much more information related to a Buffettology style of investing on this page over time, but this is what I have for today.Back to top