Warren Buffett and the Interpretation of Financial Statements

For those of you who are either new to financial statements, or want to learn how to read financial statements like Waren Buffett does, and better understand “what he saw”, there is this fantastic easy-to-read little book:

Warren Buffett and the Interpretation of Financial Statements: The search for the Company with a Durable Competitive Advantage

from Simon & Schuster. Check it on Amazon.

Forget P/E ratios when buying stocks! This book invites you to put your focus on what really matters: Gross Margin; SG&A; EBIT Margin; Earnings / Price ratio; Fixed assets; R&D expenses; Retained earnings and growth in Retained earnings; Debt; Return on Equity; Return on Assets.

Interestingly you will also learn why Warren does like high-tech firms – they have to spend huge amounts of money on R&D to keep their competitive advantage; and even then, their durable advantage might wear out. Think of Nokia and how its market capitalisation went down from USD 78bn in early 2006 to USD 7bn in July 2012 (-90%). Warren does not like that, and the book explains why these stocks are not the right ones to become mega-rich over the long term. And why buy stocks if you don’t want to become rich?

Even more important, you will learn how Warren looks at a share as an ‘equity bond’ i.e. its pre-tax earnings (equivalent to the bond coupon / interest payment), the historical growth of earnings and their relation to the current share price. When Warren bought Coca-Cola in the late 80s at USD 6.5 a share, he bought shares in a company that was essentially generating a pre-tax earning of 11% on his USD 6.5 investment, and had been growing its earnings at an annual rate of 15% historically. 20 years later, Coca-Cola generates an EBIT per share of more than USD 4, so the company is paying Warren a pre-tax yield of 60% (post-tax 40%) on his initial investment. Do you know a bond that increases its coupon from 11% to 60% over 20 years?

Whatever the current stock market price of Coca-Cola is, the Coca-Cola ‘equity bond’ was a fantastic investment for Warren. And whatever the ups and downs on the stock market, the market eventually recognises this kind of performance and increases the price of the shares to a level that reflects their true value. And the value of a Coca-Cola share is around USD 76 in mid-July 2012…