đŻ The Book in 3 Sentences
đĄ Key Takeaways
- Buffett emphasizes understanding financial statements, applying key ratios, and investing in companies, not just stocks.
- Buffettâs approach involves vigilant leadership, persistent products, stock stability, and buying at attractive prices.
- Buffett highlights how interest rates affect business, making low rates attractive for investments and economic growth.
- Focus on low debt, high current ratio, consistent return on equity, and appropriate management incentives.
- Buffett seeks companies with persistent products, tax efficiency, stable book value growth, and sustainable competitive advantages.
- Emphasizes a wide margin of safety, low price-earnings ratio, low price-to-book ratio, and discounted cash flow for intrinsic value determination.
- Explains the intricacies of income statements, balance sheets, and cash flow statements, offering insights for stock investors.
â Top Quotes
Value investors view the stock market differently than other investors. They donât believe that the stock market consists of stocks. They know that the stock market consists of real companies.
The market doesnât offer value; it offers price.
đ Summary + Notes
Chapter 1. How to Look at the Stock Market
- Stock market moves in the short term due to emotions and in the long term due to value.
- As a stock investor, you should almost always hope for the market to drop. There is one rare exception: when youâre bound by time.
- Great investors can control their emotions.
- Before you even start to think about entering a new investment, always ask: âDoes it generate any cash flow back to me?â
- You will soon realize that investments like precious metals, wine and art are bad alternatives to stocks because they donât create consistent cash flow.
Chapter 2. Concepts Every Investor Should Know
Interest rates
- When interest rates rise, business becomes more difficult and vulnerable. This is because businesses canât borrow money at cheap and affordable prices.
- When interest rates are low, companies can borrow for less.
- This makes new investments more attractive, which again leads to more employment and higher wealth.
- When money is cheap, typically stocks are too. This is the most important time to accumulate as many shares as you can.
Inflation
- You have to consider it for your % gains.
Bonds
- From 1928-2011, long-term bonds averaged 5.4% and stocks averaged 11.2%.
- From 2002-2011, long-term bonds averaged yearly returns of 6.85% and stocks 4.93%.
| Low Interest Rates | High Interest Rates | |
|---|---|---|
| Low Inflation | Stocks | Bonds |
| High Inflation | Stocks | Stocks |
Chapter 3. A Brief Introduction to Financial Statements
- **The income statement**: How much profit the company has made in one year.
- **The balance sheet**: How much does the company worth right now.
- **The cash flow statement**: How cash is moving in and out of the company.
- The income statement is capturing the profit of the business over time, and the cash flow statement is looking at the changes in cash over time.
- 10K (Annual Report): The annual accounts that are filed for all major business activities conducted in the last year. Must be filled within sixty to ninety days after the fiscal year ends.
- 10Q (Quarterly Report): These reports are a lot like the 10K but only cover the previous quarter and must filled their quarterly within forty to forty-five days from the end of the fiscal quarter.
- 8K (Current Report Filing): Publicly traded companies are also required to file a form that reports any major event that could have an effect on the companyâs financial position.
Chapter 4 The Principles and Rules of Value Investing
- Warren Buffett invests according to four simple principles:
1. Vigilant leadership
- **Rule 1âLow debt**
- Calculate Debt-to-Equity (D/E) ratio. $D/E = \frac{Liabilities}{Assets - Liabilities}$
- Prefer a $D/E < 0.5$.
- This is just a rule of thumb. Some industries are characterized by low debt-to-equity ratios; while banks, with a core product of debt, typically have higher ratios. You should therefore also consider the industry standard for normal levels of debt.
- **Rule 2âHigh current ratio**
- $CURRENT\ RATIO = \frac{CURRENT\ ASSETS}{CURRENT\ LIABILITIES}$
- Warren Buffet generally likes current ratio between $1.5$ and $2.5$.
- A low current ratio may mean that the company has problems meeting their short-term obligations
- A higher current ratio (over 5%) may indicate bad money management due to an inability to collect payment from vendors.
- **Rule 3âStrong and consistent return on equity**
- $ROE = \frac{Net\ Income}{Shareholdersâ Equity}$
- The $ROE$ shows the effectiveness of managementâs ability to reinvest the profits in the business.
- $ROE$ is Warren Buffettâs favorite number.
- Look for companies that have had a consistent $ROE$ of above 8% over the last ten years.
- 8% alone is not enough. Look also the trend. You want to look for a $ROE$ that has been steady or even increasing over the last eight to ten years.
- Look at the industry for comparison. In the insurance industry, a steady trend of around 8% may be fine, but in the IT industry, it might not be adequate.
- **Rule 4âAppropriate management incentives**
- Look at how management is compensated.
- Look at the notes in the annual report.
- You want a company that discloses how much the base salary is and how much is variable, and which indicators the management is measured on.
2. Long-term prospects
- **Rule 1âPersistent products**
- Invest in a product that will not change in the next thirty years.
- A product that has been here for thirty years and can be expected to be here for at least another thirty years is a good place to start your search for valuable companies.
- **Rule 2âMinimize taxes**
- The tax system favors the value investor over the average investor.
3. Stock stability
- **Rule 1âStable book value growth from the ownerâs earnings**
- Book value is equity.
- Look for a steady earnings per share ($EPS$), Dividend, Book value per share increase over time.
- **Rule 2âSustainable competitive advantage (moat)**
- For example, WalMart buys on such large volume that it can buy products from its suppliers at a cheaper price than its competitors.
- Intangible assets such as brands and patents are one type of moat.
- Low cost is another type of moat.
- High switching costs is another type of moat.
4. Buy at attractive prices
- **Rule 1âKeep a wide margin of safety to the intrinsic value**
- Intrinsic value is the companyâs real or fair value, regardless of what the stock price is.
- **Rule 2âLow price-earnings ratio**
- $P/E = \frac{Market\ Price\ of\ the\ company}{Net\ Income}$
- A $P/E$ of 10 means that every ten dollars of price towards the stock should give you one dollar of earnings.
- $P/E$ is a snapshot and doesnât guarantee that it will remain the same in the future.
- $Forward\ P/E=\frac{Market\ Price\ of\ the\ company}{Projected\ Net\ Income}$
- Warren Buffet suggests stocks with $P/E < 15$.
- **Rule 3âLow price-to-book ratio (P/B)**
- Book value is the equity (assets-liabilities).
- $P/B$ measures how much the investor pays for every $1 of the companyâs equity.
- $P/B = \frac{Market\ Price\ per\ share}{Book\ Value\ per\ share}$
- It can be misleading if studied alone. Companies with low $P/B$ might be dying companies.
- Compare it with companyâs earnings, $ROE$, and debt.
- Benjamin Graham would try to find companies with a $P/B$ ratio below 1.5.
- **Rule 4âSet a safe discount rate**
- By using a discount rate, an investor can take future dollars (or expected dollars) and turn them into present dollars.
- So if a company XYZ is worth $100 and trades for $80. That $100 value is called the intrinsic value, or real value and has a 20% discount rate.
- Discount rate should be higher than 3%.
-
Rule 5âBuy undervalued stocksâDetermining intrinsic value
### The Discount Cash Flow (DCF) Intrinsic Value Model
Steps to calculate:
1. Estimate the free cash flow
- Free cash flow is the profit that can be paid to the owners without negatively impacting future performance.
- The formula for determining the free cash flow for any given year into the future is the following:
- $FCF_n=BYFCF(1+GR)^n$, where
- $FCF_n$ is the free cash flow in year $n$
- $BYFCF$ is the base year free cash flow (the cash flow now)
- $GR=Estimated\ Annual\ Growth\ Rate$
- Be accurate, be balanced, and be careful (the ABCs) when selecting a future growth rate.
- A great starting point for picking a percent would be an assessment of the companyâs historical free cash flow growth rate.
- Another starting point could be the companyâs average return on equity ($ROE$) over the past five years. Ensure that its trend is either flat or increasing.
2. Estimate the discount factor
- $DF_n=(1+DR)^n$, where
- $DR$ is the discount rate which represents the return you would like to receive for owning the company.
- $n$ is the year being discounted
3. Calculate the discounted value of free cash flow for ten years
- $DFCF_n=\frac{FCF_n}{DF_n}$, where
- $DFCF_n$ = Discounted free cash flow for year $n$
- Once each yearâs $DFCF$ is determined, all the years are summed together.
4. Calculate the discounted perpetuity free cash flow (beyond ten years)
- $DPCF=\frac{BYFCF(1+GR)^{11}(1+LGR)}{DR-LGR}\frac{1}{(1+DR)^{11}}$, where
- $DPCF$ = Discounted perpetuity cash flow
- $BYFCF$ = Base year free cash flow
- $GR$ = Growth rate of the free cash flow
- $DR$ = Discount rate
- $LGR$ = Long-term growth rate
- Set $LGR$ between 2%-3% if you think this company going to have the capacity to remain relevant beyond ten years.
5. Calculate the Intrinsic value
- $Intrinsic\ value = Sum\ of\ DFCF\ for\ ten\ years + DPCF$
6. Calculate the Intrinsic value per share
- See the Common Share Outstanding or Ordinary Shares Outstanding of the balance sheet or Income statement to see how many common shares are outstanding in the company.
- $Intrinsic\ value\ per\ share = \frac{Intrinsic\ value}{Common\ shares\ outstanding}$
So an Intrinsic value share of $17.99 means that if you could buy one share of company XYZ at $17.99 you could expect a 10% annual return (assuming 10% Discount Rate).
The intrinsic value is completely dependent on the return you seek.
### The BuffettsBooks Intrinsic Value Model
- The calculation is given in the bookâs website.
- **Rule 6âThe right time to sell your stocks**
- When the company starts violating Buffetâs 4 rules.
- Another valid reason for selling a stock would be if you feel that the stock is taking up too much of your portfolio.
- Sell your stock if you can place your money in another, more profitable, investment.
Chapter 5. Financial Statements and the Stock Investor
- Accrual accounting simply states that expenditures must be recorded when incurred and not when paid.
- Similarly, revenue must be recorded when there is an outflow of services or goods, not when the payment is realized.
- Prior to 1987, companies only reported their financial information on the income statement and balance sheet.
Chapter 6. Income Statement in Detail
- The income statement is also referred to as the profit and loss statement, the statement of operations, and the statement of income.
- It shows a companyâs profitability over a given period of time.
- Income statements always seem to have different lines and the names of the accounts can change depending on which company you are looking at.
- For example, one company might call revenue, âturnoverâ and another company may seem to forget to include depreciation, while a competitor has disclosed is as a major expense.
| 1 | Revenue | 13,279 | Revenue from primary activities. Îll the sales the company makes. Also named: Sales or Turnover. For details of revenue, find a section titled Net Operating Revenues in the Financial Statement. | | â | â | â | â | | 2 | Cost of revenue | 5,348 | Expenses generated from primary activities. Also named: Cost of Sales, Costs of Goods Sold and Production Costs. For details on the derivation of this number, you can dig into the accounting policies in the annual report. | | 3 (1-2) | Gross Margin | 7,931 | Also named: Gross Profit or Gross Markup. | | 4 | Sales and Marketing expenses | 1,105 | Expenses generated from secondary activities. This line is sometimes combined with Administration Expenses and called SGA (Selling, General and Administration). | | 5 | Research and development expenses | 863 | Expenses generated from secondary activities. | | 6 | General and Administration expenses | 538 | Expenses generated from secondary activities. | | 7 | Other operating expenses | 1,350 | Total expenses generated from secondary activities. | | 8 (4+5+6+7) | Operating expenses | 3,856 | | | 9 (3-8) | Income from operations | 4,075 | Also named: Earnings Before Interest and Taxes (EBIT) | | 10 | Net interest income/(expenses) | (135) | Revenues from secondary activities or expenses for financial activities if it is in parenthesis. Also named: Financial Items or Other Income if it also includes other revenues not made from financial activities. Sometimes this line is broken into two, namely Net Interest Income and Net Income Expense. | | 11 | Extraordinary income/(expenses) | 275 | Gains or loses if it is in parenthesis. It is something that is not part of the daily operations and cannot be predicted. Might referred as Gain (Loss) on Sale of Assets. | | 12 | Income taxes | 1,352 | Just above the line labeled Income Taxes, you will sometimes find a line called Income Before Tax or Pretax Income. | | 13 (9+10+11-12) | Net income | 2,863 | How much profit the company has made during the year. Careful on lines 10, 11 if it is in parenthesis, then subtract it. Also named: Profit for the Year or Net Income from Continued Operations. |
Ratio Analysis
Use ratios to compare companies of the same sector.
- $Gross\ Profit\ Margin\ Ratio = \frac{Gross\ Margin}{Revenue}$
- A $GPMR$ of 59.7% means that every time Coca-Cola sells soft drinks for $100, it makes $59.7 in gross profit.
- $Operating\ Margin\ Ratio = \frac{Income\ from\ Operations}{Revenue}$
- $Net\ Income\ Margin\ Ratio = \frac{Net\ Income}{Revenue}$
- Trend analysis is the heart of understanding the prospects for future performance. Check the ratios for all years.
- $Interest\ Coverage\ Ratio = \frac{Income\ from\ Operations}{Interest\ Expense}$
- An $ICR$ of 30.2 means that the company would be able to pay the interest expenses as much as 30.2 times from the operating income.
- Seek for $ICR > 5$.
Chapter 7. Balance Sheet in Detail
- Assets are something that is owned and expected to generate income for the company.
- Assets can be financed two ways: with the companyâs moneyâthis is called *equity;* or with someone elseâs moneyâthis is called *liabilities.*
- A current asset can be defined as any asset which is likely to be converted into cash within a period of one year.
- Non-current assets are sometimes referred to as long-term assets. An organization simply includes those assets that have an expected ownership over a period exceeding one year and cannot immediately be converted into cash.
Assets
| Cash and cash equivalents | 1,847 | Also named: cash, cash equivalents, and marketable securities. |
|---|---|---|
| Accounts receivable | 3,897 | Money that is expected to flow into the company but is yet to be received. |
| Also named: receivables, or net receivables. | ||
| Inventory | 2,486 | Typically, subdivided into three categories: raw materials, work in progress, and finished goods. |
| Also named: stock. | ||
| Other current assets | 638 | |
| Prepaid expenses | 285 | Represent advance payments for future goods or services, considered assets until utilized. |
| Total current assets | 9,153 | |
| Non-current receivables | 1,811 | Amount of money that the company expects to get back from another party not within the next 12 months. |
| Non-current investments | 2,7687 | Also named: long-term investments. |
| Property, plant, and equipment | 8,292 | Also named: PPE. |
| Patens, trademarks, and other intangibles | 1,827 | Patents and trademarks provide a durable competitive advantage for a company, it is a great source of risk reduction. |
| Intangible assets are generally unaffected by inflation. | ||
| Goodwill | 3,235 | Τhe goodwill usually represents the residual impact of past acquisitions. When Company A acquires Company B, the difference between the price paid and the âfairâ net value of company Bâs assets appears on company Aâs balance sheet as goodwill. |
| Total non-current assets | 17,933 | |
| Total assets | 27,086 |
Liabilities
| Accounts payable | 2,183 | Also named: payables, net payables, or trade payables. |
|---|---|---|
| Notes payable | 498 | How much of the outstanding short-term debts should be paid back to the issuer. |
| Also named: current borrowing or current financial debt. | ||
| Accrued expenses | 854 | Expenses that are not yet paid for (employeesâ salaries, electricity bills, etc). |
| Taxes payable | 427 | |
| Total current liabilities | 3,962 | |
| Long term debt | 3,211 | Very important line. |
| Loans that have been obtained by the company. | ||
| Deferred tax | 1,242 | A tax balance adjustment. |
| It fixes overpaid or underpaid taxes when accounting and tax rules differ over an itemâs value. | ||
| Provisions | 273 | Funds set aside to cover anticipated losses or expenses, particularly related to potential defaults on payments from customers. |
| Total non-current liabilities | 4,726 | |
| Total liabilities | 8,688 | |
| Share capital | 400 | The amount of money that investors have contributed to a company by purchasing its shares |
| Also named: capital stock, common stock, or paid-in capital. | ||
| Additional paid in capital | 3,261 | The extra amount of money that shareholders paid for their shares beyond the face value of those shares. |
| Retained earnings | 15,590 | The sum of all the previous net incomes the company has produced. |
| Treasury stocks | -853 | The companyâs own shares it bought back. |
| Total equity | 18,398 | |
| Total liabilities and equity | 27,086 |
Ratio Analysis
Use the below to compare with competitors and over many years.
Profitability ratios:
- $ROE$ (See Chapter 4).
- $Return\ on\ Assets\ (ROA)=\frac{Net\ Income}{Total\ Assets}$
- Sometimes called $Return\ on\ Investement\ (ROI)$
- Seek $ROA > 6\%$
- This ratio isnât that important to calculate if youâre buying a company with very little debt.
- For a company with high Debt to Equity Ratio ($D/E$) use $ROA$ instead of $ROE$.
Liquidity ratios:
- $Current\ Ratio = \frac{Current\ Assets}{Current\ Liabilities}$
- Also in Chapter 4.
- Should be above $1.5\%$. If above 5% it might indicate bad money management.
- $Acid\ Test\ Ratio = \frac{Current\ AssetsâInventory}{Current\ Liabilities}$
- Some call the acid test ratio a conservative approach to the current ratio.
- The less you know about the company, the more you should prefer this key ratio over the current ratio.
- Should be above $1.5\%$.
Efficiency ratios:
- $Inventor\ Turnover\ Ratio = \frac{Cost\ of\ Revenue}{Inventory}$
- Show how efficient is the company in turning the inventory into sales.
- For products with a somewhat high duration it should be above $4$.
- $Accounts\ Receivable\ Turnover\ Ratio = \frac{Turnover}{Accounts\ Receivables}$
- To understand, convert into days. Assuming annual report, divide 365 with the ARTR. If the number is 107 it means that the company typically takes 107 days to receive payments from their customers.
- A good ratio can be between 5 and 7.
- $Accounts\ Payable\ Turnover\ Ratio = \frac{Cost\ of\ Revenue}{Accounts\ Payable}$
- Convert also in days. A 149 would mean that the company takes on average 149 days to repay their suppliers.
- A good ratio can be between 2 and 6.
Solvency ratios:
- $D/E$ (See Chapter 4).
- $Liabilities\ to\ Equity\ Ratio = \frac{Total\ Liabilities}{Equity}$
- A $L/E$ of 47.2% means that every time the shareholder has $100 in equity, the company would have to pay out $47.2 at some point in the future.
- Should be $< 0.8$.
- More conservative value investors like to look at this key ratio instead of the $D/E$.
Chapter 8 Cash Flow Statement in Detail
| 1 | Net Income | 2,863 | The starting point from which we start to adjust. It is the last line in the income statement. |
|---|---|---|---|
| 2 | Depreciation | 516 | We must add depreciation back because it was a non-cash item in the income statement (where it reduced the net income). |
| Also named: depreciation and amortization or is simply grouped into a line called non-cash items. | |||
| 3 | Other non-cash items | 264 | |
| 4 | Deferred taxes | 287 | |
| 5 | Working capital | -832 | |
| 6 (1+2+3+4+5) | Cash flow from operating activities | 3,098 | The cash made from the company business activities. |
| 7 | Property, plant, and equipment, net | -1,349 | Also named: Capital Expenditures, cap spending, or simply CAPEX. |
| 8 | Intangible assets, net | -214 | |
| 9 | Businesses, net | 86 | |
| 10 | Investments, net | -176 | |
| 11 (7+8+9+10) | Cash flow from investing activities | -1,653 | |
| 12 | Issuances of common stock | 98 | |
| 13 | Purchase of stock for treasury | -326 | |
| 14 | Payment of cash dividends | -682 | |
| 15 | Issuances/payment of debt, net | -120 | |
| 16 (12+13+14+15) | Cash flow from financing activities | -1,030 | |
| 17 (6+11+16) | Change in cash | 415 | |
| 18 | Cash and equivalents, start of period | 1,432 | |
| 19 (17+18) | Cash and equivalents, end of period | 1,847 |
Ratio Analysis
- $Free\ Cash\ Flow\ (FCF) = Operating\ cash\ flow + Property,\ Plant,\ and\ Equipment,\ net$
- $Free\ cash\ flow\ to\ revenue\ ratio = \frac{Operating\ Cash\ Flow + Property,\ Plant,\ and\ Equipment,\ net}{Revenue}$
- A value of 13% would mean that every time the company has revenue of $100, $13.2 will be available as cash for the shareholders.
- Look for for a consistent value above $5\%$.
- $Investing\ cash\ flow\ to\ operating\ cash\ flow\ ratio = \frac{Investing\ Cash\ Flow}{ Operating\ Cash\ Flow}$
- A value of 53.3% would mean that every time the company makes $100 in cash from its operations, $53.3 in cash are spent on maintaining and investing in the companyâs growth.