Warren Buffett: Buy a Dollar for 50 Cents

By Daniel Miller - September 12, 2012 | Tickers: AAPL, BRK-A, DAL, GRPN, IPGP | 0 Comments

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Raise your hand if you want a crash course over the income statement from Warren Buffett! Here’s a handful of tools so simple a caveman can do it. Using these tools, Warren searches the universe for companies with a durable competitive advantage. Finding those companies is key for building wealth.

Some time ago, I read “Warren Buffett and the Interpretation of Financial Statements” by Mary Buffett & David Clark. Warren bought into the idea that if you found a fair priced company with a durable competitive advantage and economic moat, you could ride it to riches. He’s built his wealth to extraordinary levels and created an empire like company in Berkshire Hathaway (NYSE: BRK-A). I’ll cover a handful of these analytics while showing examples of companies that pass with flying colors and others that crash and burn. The companies Apple (NASDAQ: AAPL), IPG Photonics (NASDAQ: IPGP), Groupon (NASDAQ: GRPN), Delta Air Lines (NYSE: DAL) are unrelated, but showcase great examples. Let’s start from step 1.

 Gross Profit Margin

This is the first step to getting Net Margin, which we’ll look at next. The reason to look at GP Margin is to simply understand whether or not this company produces products that have very little pricing pressure. This leads us to companies with a potential competitive advantage and a favorable economic moat. GP Margin over 40% has a great start and anything under 20% isn’t good news. Groupon takes a huge lead and is clearly producing a valuable product, very cheaply. Apple and IPGP are still in great condition, while Delta is already crashing and burning. GP Margin leads you to a company with a solid product value.

That’s a good start. What if the company is run by a group of morons? What if the company has insane competition forcing the use of revenue to stay competitive? Net Margin helps put that in perspective by using GP Margin and taking account of Operating Expenses, Depreciation, Interest Expense and others. Let’s look at operating expenses, I took out the outliers AAPL and DAL.

 Operating Expenses

Did you scroll up to double check that Groupon started with over 4x more revenue than IPGP, yet finished with under half their Net Income? That’s why Warren invests in companies with an economic moat!

Operating Expense is a great section to see if any expense is too costly. You can confirm that those in charge aren’t using toilets made of gold, by checking that General & Administrative costs aren’t sky high. Sales and Marketing is useful to know if they have a marketing campaign that’s bankrupting them to create revenue. R&D is very important to understand if the company is spending all its revenue to stay competitive with new innovations. Using these numbers as a percentage of Gross Profit will have varied results depending on the company. The thing to look for is consistency, a company that has very volatile percentages should raise a red flag for further research. So, how does it look after Operation Expenses, Taxes, Depreciation and others?

 Net Margin

Groupon Started with a huge GM% lead on Apple and IPGP, and Delta had already crashed on the runway. However, Groupon has to spend so much revenue to stay competitive it destroys their financials. The barrier of entry to compete with Groupon is extremely low making it difficult to sustain a competitive advantage. IPGP has a strangle hold on their industry with it's incredible patents, while Apple has that and massive intangible assets including their Brand name itself.

Net Margin can present you with a picture of whether a company really has a competitive advantage or not. A company that has a historic percentage over 20% is taking their competitive advantage all the way to the bank. Companies under 10% are likely in a highly competitive industry with few competitive advantages. It should be noted that banks generally are excluded from this analysis.

Now we know which companies have a competitive advantage. Hint, it’s not Groupon OR Delta. Which companies are destined for you to ride to riches? Let’s take a look at a last set of tools to get a little better grasp on each company. Here are two simple but effective tools. Return on Equity is a measurement of capital efficiency, and shows what a company can return on the existing capital base. A historic value of 20% is considered above average. The second, Long Term Debt to Capitalization, can show that a rising debt leverage without a rise in RoE could cause cash flow problems and should raise a red flag for further research. LTD% above 40-50% should be a warning. How do these companies stack up?

Bottom Line

Both companies boast numbers worthy of investment. IPGP is an elite company that has made huge strides in their RoE%. I believe they have a durable competitive advantage and little debt. This company has every key ingredient to be a Buffett stock. That being said, AAPL is the greatest company today. It's difficult to be bearish on Apple.

Warren believes in gaining wealth by buying a dollar for 50 cents. He also believes in buying fairly priced companies that prove they have a durable advantage. We’ve proved both AAPL and IPGP possess these qualities on paper. Now the rest is to define if there is an ongoing demand for these products and if the company posts consistent results. These tools are simple, but extremely effective in identifying the most important aspects of a company.

Use them wisely…

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