What does Buffett look for when reading financial statements

 

The book "Warren Buffett and the Interpretation of Financial Statements" gives us a few clues.

In the book he outlines each rule, keep in mind these are not set in stone.

1. Gross profit margin of 40% or higher. 

This indicates that the company has a strong competitive advantage and can charge a premium price for its products or services.

For example, both $KO and $AAPL carry > 40% gross margins at 58% and 43% respectivley.

2. Return on equity (ROE) of 15% or higher.

This shows that the company effectively uses its shareholders' equity to generate profits.

Buffett mentions ROE many times thru his shareholder letters, both $AXP and $KO earn ROE's of > 15%, with 38% and 29% respectively.

3. Persistently growing earnings per share (EPS).

This indicates that the company is a good investment for the long term.

$AXP have generated over 9.2% EPS growth over the past 10 years, this typifies what Buffett wants to find.

4. Low debt-to-equity ratio.

Indicates the company is well-versed and is less likely to default on its debt.

Look for something < 1 to start and then expand.

5. Adequate cash flow.

Indicating the company has enough cash to meet its operating expenses and make debt payments.

His version of "cash flows" refers to owners' earnings.

6. Strong balance sheet.

The company has assets > than its liabilities. 

A strong balance sheet enables a company to withstand unforseen problems, ie Covid.

7. A history of dividend payments.

Shows the company is profitable and committed to returning capital to shareholders.

Buffett likes companies paying divvies, even though he doesnt pay them himself. 

8. Management team that is honest and competent.

This is a biggie for Buffett because the management team is responsible for running the company and making decisions that affect its shareholders.

9. A business that is easy to understand.

If you don't understand the business, it will be impossible to analyze.

Buffett is famous for his "too hard" pile.

10. A business that is not cyclical.

He prefers steady, consistent earning businesses, but he will break his rules, ie. oil.

11. A business that has a moat.

Another biggie for Buffett. 

He prefers companies that can earn great returns over long periods while fending off competition. 

12. Business that is undervalued.

He likes deals, and he wants to buy his stocks like his socks, on sale.

13. Business that you are comfortable owning for the long term.

Remember investing is a long-term game. 

Think Gillette, Hanes, Coca-cola, or Dairy Queen.

14. Don't be afraid to walk away from a deal.