- Gross Profit Margin: firms with excellent long term economics tend to have consistently higher margins
- Durable competitive advantage creates a high margin because of the freedom to price in excess of cost
- Greater than 40% = Durable competitive advantage
- Less than 40% = competition eroding margins
- Less than 20% = no sustainable competitive advantage
- Consistency is key
- Sales Goods and Administration: Consistency is key. Companies with no durable competitive advantage show wild variation in SG&A as % of gross profit
- Less than 30% is fantastic
- Nearing 100% is in highly competitive industry
- R&D: if competitive advantage is created by a patent or tech advantage, at some point it will disappear.
- High R&D usually dictates high SG&A which threatens the competitive advantage
- Depreciation: Using EBITDA as a measure of cash flow is very misleading
- Companies with durable competitive advantages tend to have lower depreciation costs as a % of gross profit
- Interest Expenses: Companies with high interest expenses relative to operating income tend to be either: 1) in a fiercely competitive industry where large capital expenditure required to stay competitive 2) a company with excellent business economics that acquired debt in leveraged buyout
- Companies with durable competitive advantages often carry little or no interest expense.
- Warren’s favorites in the consumer products category all have less than 15% of operating income.
- Interest expenses varies widely between industries.
- Interest ratios can be very informative of level of economic danger.
- Important: In any industry, the company with the lowest ratio of interest to Operating Income is usually the one with the competitive advantage.
- Net Earnings
- Look for consistency and upward long term trend.
- Because of share repurchase it is possible for net earnings trend to differ from EPS trend.
- Preferred over EPS
- Durable competitive advantage companies report higher % net earnings to total revenues.
- Important: If a company is showing net earnings history greater than 20% on total revenues, it is probably benefiting from a long term competitive advantage.
- If net earnings is less than 10%, likely to be in a highly competitive business
The Income Statement Summary Table
| (DCA = Durable Competitive Advantage) | Comments | |
| Gross Profit Margin | >40% = D.C.A. < 40% = competition eroding margins < 20% = no sustainable competitive advantage | Consistency is Key |
| SG&A (SGA as % of gross profit) | < 30% is fantastic Nearing 100% is in highly competitive industry | Consistency is Key |
| Depreciation (depreciation costs as a % of gross profit) | Company with moat tend to have lower % | |
| Interest Expenses (interest expenses relative to operating income) | Durable competitive advantages carry little or no interest expense. Buffett’s favorite consumer products have <15% | Company with lowest ratio of interest to Operating Income = competitive advantage. Varies widely between industries. |
| Net Earnings (% net earnings to total revenues) | Net earnings history >20% = Long Term moat < 10% = in highly competitive business | consistency and upward LT trend |
| EPS | 10-year period showing consistency and upward trend. Avoid erratic earnings pictures. | Consistency = sign products don’t need to change. Upward trend = strong |
Read more on the Income Statement Analysis on my previous post - http://intelligentinvestor8.blogspot.my/2014/05/income-statement-analysis.html
Or, take a look on How Buffett read other financial statements:-
- How Buffett Interprets the Income Statement
- How Buffett Interprets the Balance Sheet
- How Buffett Interprets the Cash Flow Statement
References:-
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