Long-term value investing has proven to be the best way to make money on the stock market in the long term and the “Oracle of Omaha” Warren Buffett knows it best.
Learning how to read financial statements if you want to be a serious investor is like learning how to read numbers if you want to be a mathematician: it’s more than necessary. So in the next 3 videos we are going to learn the more important positions of financial statements and in particular of the income statement, the balance sheet and the statement of cash flow, starting with the income statement in this video.
Since the goal of these videos is to learn how to invest like Warren Buffett, we couldn’t avoid dedicating the first video of the series to probably the biggest concept in Buffett’s investing strategy: the Durable Competitive Advantage. So if you haven’t seen the Part 1 of this short series, you must check it out first because the Durable Competitive Advantage is a concept that Buffett always remarks as extremely important in picking stocks and it’s a concept that you’ll see repeated several times in these videos. If you’ve already watched that video, or if you already know everything about the Durable Competitive Advantage, well, then your journey continues here.
Hello everyone, this is Rick Dago and in my channel we talk about self-development, finance and productivity. Today we continue with the series about “how to invest like Warren Buffett”, focusing now on one of the most important financial statements: the income statement.
Now, I already asserted in a disclaimer in the first video, that as private investors we can just pick some basic concepts of how Warren Buffett works, but we can’t really expect to be able to invest LIKE him for the simple reason that a person in his position finds deals on another level. He doesn’t buy stocks from a trading app at the market price and he has access to a huge amount of information that we can only dream about having. So what about us? Maybe we are not able to have a private meeting with the Board of Directors of a company to discuss buying 2 billions of preferred stocks, like Warren Buffett does. Nevertheless, as private, individual investors we have free access to the financial information of every publicly traded company and we can and should always rely on this information in order to evaluate if we should invest in a company or not.
Understanding financial statements is something that can scare some people, above all if you never really studied finance or aren’t so good with numbers, but let me explain all the basic concepts in this video and I can assure you that after this you will not be frightened by these statements anymore and you’ll see them as tools for better decision making.
As Buffett says, “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” So how does Buffett find these wonderful companies? Generally speaking, the most important term to remember is the DCA: Durable competitive advantage or Long Term Competitive Advantage.
I talk about the durable competitive advantage in detail in the first video of this series. So since this is the most important concept to understand, if you didn’t see that video of mine I suggest you watch that first – I’ll put a link somewhere here – then come back to this video.
So, assuming that you know everything about the DCA, we’ll focus now on the first of the 3 financial statements that you need to become comfortable with, the income statement. Let’s get it started.
What is the Income Statement?
The Income statement tells you how much money the company earned in a quarter and a year. It tells you the profit margins, some interesting ratios like Return On Equity (ROE), and it allows you to check the consistency and the duration of the earnings by comparing the last 5 to 10 years. All these factors are fundamental to check if the company benefits from a durable competitive advantage. But where do you find this financial information?
All publicly traded companies must file the so-called Annual report, which is usually a long, descriptive report that a company prepares for its shareholders and describes the company’s financial condition and operations over the previous year. If you don’t have the aspiration to invest as much time as Warren Buffett into reading financial reports, you can just read the numbers in the so-called 10k. The 10k is an annual report that all the publicly traded companies must publish and it’s much more concise than the shareholder’s annual report. And most of all in the 10-k you easily find the financial statements like the Income statement.
Where to find the Income Statement?
All the historical data of the financial statements, including Income Statement, can be found in sites like yahoo finance or morningstar and, compared to the 10k, in these websites you have the advantage to find the financial data of the last 10 years, allowing you to look for the consistency that you want to find in a company with a durable competitive advantage. Now, let’s look for example at the last 10k of Coca Cola. To find it, google coca cola and when you get to the website go to Investors, Filings and Reports and then select Annual filings – 10k:
Now, this 10-k is 183 pages long but don’t worry, scrolling down we find the table of contents which is usually clickable in any 10-k. So let’s select Financial Statements and supplementary data and we jump to page 59 where we find a new table of content. As you can see, at the beginning we have the Consolidated Statements of Income, and after this Consolidated Statements of Comprehensive Income you also have the Consolidated Balance Sheets and Statements of Cash Flows, which we will analyze in the next two videos.
So let’s go to page 60 and let’s check the Statement of Income.
So, as you can see this is the consolidated statement of Income and contains all the income information from Coca Cola from the last 3 years. Now, before diving deep into the most important positions of the income statement, let me show you where you can find this information without having to go to the 10-k on the company’s website. There are many websites that collect this data but two of my favorites are Morningstar.com and QuickFS.net. Not only can you get the same information for every company but you also have the advantage of getting 5 to 10 years of data in one page.
For example if I go to QuickFS.net and I type KO, which is the Ticker of Coca Cola, I get an overview of the financial numbers of the company. If I click on the right side and choose Income Statement, I get the income statement of Coca Cola of the last 10 years. Now notice that the numbers are the same as in the 10k. Check for example the revenue of 2021, it’s 38,655 – this is of course millions, so it’s 38 billions. If you check the Consolidated statement of income from the official Coca Cola 10-k you’ll find the same number under Revenue. Here you go.
Since we are here, let me also show you how to get this information in Morningstar. You need to go to the website, and on the top left you type KO, again the ticker from Coca Cola, then you click on Key Ratios and then on Full Key Ratios Data. This is going to make you land on a page that contains all financial data from Coca Cola. You got the key ratios here and if you click on Financials you can check Income Statement (wait), Balance Sheet (wait) and Cash Flow (wait). Notice that in morningstar now, since around 1 year, you can only see 5 years back if you are not a premium member.
Deep dive into the Income Statement
Now, what does the income statement do: the Income statement tells the investors the results of the company’s operations for a set period of time (a quarter or a year).
Income Statements have 3 main parts:
- The revenue of the business
- The expenses
- The net profit, obtained as revenue – expenses
Basically, to understand from the income statement if a company has a DCA or will struggle to keep itself alive, following Buffett’s strategy you should look at these 3 points:
What kind of margins the company has, if it needs to keep using R&D to keep itself competitive, and if it uses leverage to make money. Moreover, the SOURCE of the earnings is more important than the earnings themselves.
So, let’s see now what are the most important items of the income statement, how to interpret them and how we can use them to see if we are looking at a strong, promising company or not.
Revenue: where the money comes in
First line is total or gross Revenue: all the money that came in the door during the period in question (quarter or annual). Now, the revenue is the money that comes in before expenses, so it’s not an earning. If you sell 10.000$ of products but you spent 8000$ to produce them, your revenue is going to be 10.000$ but your earnings are going to be 2000$, namely 10.000-8.000$.
So Total revenue – Expense of business = Net earnings (NE) or Net Income, which is the number you see here at the end. Everything that stands here between the Revenue and the Net Income are all the expenses of the company.
Now, what should the revenue look like? Ideally, the revenue should be a growing value in the last 10 years, to show that the company is expanding. Of course, Revenue is not all because the Net earnings must also grow, but we’ll see that later.
Cost of Goods Sold (Cost of Sales) / Cost of Revenue
Right after the Total Revenue you have the Cost of goods sold/ Cost of revenue.
The cost of goods sold, as the term itself explains, means the cost that the company had to spend to manufacture the products they sold.
The term Cost of revenue instead of Cost of Goods Sold, is used if the company sells services instead of goods or products.
COGS does not tell us much about DCA, but it is essential in calculating the Gross profit.
Gross Profit and gross profit margin
The Gross profit is nothing other than Revenue less COGS. GP does not include “Sales & Administration Costs” , “depreciation” and “interest cost”. It doesn’t tell us much about the presence of a DCA, but Gross Profit Margin does. To calculate the Gross Profit Margin you divide Gross Profit by Revenue. This margin gives you an indication of how profitable the sale of products and services for that particular company are because it tells you how much revenue stays within the company after paying the Cost of the goods sold.
A Durable competitive advantage in a company usually creates a high margin because such companies can price their goods much higher than what they paid to produce them.
Firms with excellent long term economics tend to have consistent and stable higher margins, so first of all you should look for a gross profit margin which is constant or growing within the last 10 years. As regards the value, there is no magic formula but in general:
- Greater than 40% = Durable competitive advantage
- Less than 40% = competition eroding margins
- Less than 20% = no sustainable competitive advantage
And remember: Consistency is key. Always look at 10 years of data, don’t trust only the last .
Now, after the cost of goods sold have been deducted by the revenue, the expenses for the company are still not over because they still have to face general operational expenses which are not directly related to single products. These are called operational expenses because they are related to the operation of the business. A company may have a high gross profit margin because they have low COGS, but still they can lose money on the long run because of high Operating Costs, which can be:
- Research and Development Costs (R&D)
- Selling, General & Administrative Expenses
- Depreciation and Amortization
- Restructuring Charges
- Non operating and non recurring expenses
In the case of Coca Cola we only have Selling, General & Administrative Expenses and then Other general charges. So, if you deduct all operating expenses from the gross profit, you obtain the Operating income or Operating Profit.
Gross Profits – Total operating expenses = Operating profit (or loss).
Now let’s see some of these Expenses in detail.
Selling, General and Administrative Expenses (SGA)
They include Management salary, payrolls, travel costs, legal fees etc. and they have a tremendous impact on the company’s bottom line.
Coca Cola CONSISTENTLY spends 56-59% of its gross profit on SGA. Moody CONSISTENTLY spends 25% of its gross profit on SGA. Procter & Gamble CONSISTENTLY spends 60-61% of its gross profit on SGA. CONSISTENCY is the key word!
Companies that don’t have DCA suffer from intense competition and show wild variations in SGA cost over the years. Example: General Motors has spent from 28% to 83% , Ford from 79% to 700%: Both are losing money like crazy: If Sales fall, revenues fall but SGA cost remains, cutting more and more of the company’s gross profit. You want the SGA cost to be low and consistently < 30% (if possible!)
- Less than 30% is fantastic
- Nearing 100% is in highly competitive industry
There are also companies that have low SGA Costs, but destroy themselves nevertheless with high Capital Expenditure and Interest Expense on their Debt load. An example is Intel, which has low SGA but still needs a lot of R&D, otherwise their products would become obsolete in 10 years and competition would kick them out.
Goodyear Tires is another example: it has a 72% ratio SGA/GP and also high capital expenditure as well as Interest costs on debts used to finance these capital expenditures.
Buffett stays away from companies with high SGA expenses, as well as high R&D Costs and other operating expenses.
R&D: Why Buffett stays away from it
High R&D usually dictates high SGA which threatens the competitive advantage.
Intel, for example, must spend 30% of its gross profit on R&D. If it doesn’t, someone else will take its place.
Coca Cola has no R&D, and has on average a SGA cost of 59% which remains stable.
Coca Cola buys a new machine for 1 million and this machine will be used for 10 years. Although the million was spent at the beginning, financially the machine causes depreciation expenses of 0.1 M per year which is reported every year in the income statement. The real 1M Cash Expense appears instead under Capital Expenditure in the Cash Flow Statement. Depreciation is a real cost of doing business and shouldn’t be underestimated.
Buffett says that often companies underestimate the cost of depreciation and they build debt with Leverage Buyouts and in the end can’t finance another 1 M dollar purchase after 10 years. So, companies with a DCA often manage to have low Depreciation cost compared to the Gross Profit.
Interest Expense (financing cost)
So, so far we have deducted both the costs of the products, the so-called Cost of Good Sold, and the operating expenses from the Revenue, giving us the Operating Income. But beside operational costs the company also has to face financial costs, and these are reported as Interest Expenses. And why is that? Companies have liabilities, that could be anything they rent like buildings, machines, or cars, and also debts they made with the banks to finance their operations. For all these debts the company has, they have to pay interest. As you can see from Coca Cola, there is both interest income and interest expense, because Coca Cola itself receives interest periodically from other companies. Now, if you check the income statement of banks, for example look at this one, you are going to find a higher interest income than interest expense, but for all the other companies usually it’s the other way around.
Companies with a DCA usually carry little or no Interest expense (IE).
Procter and Gamble pays only a regular 8% of its Operating income out in interest cost, Wrigley pays only 7%. Goodyear, on the other hand, in its competitive tyre business pays 40 to 60% of Operating income in IE. Same goes for airlines, which, if you follow Buffett, are usually a terrible business to invest in: United Airlines for example pays between 60 and 100% in interest expenses and goes on and off bankruptcy risk every year. American Airlines also has a negative operating income and still pays a lot in Interest Expense.
As a rule of thumb, a good company would have less than 15% of Operating Income consumed by Interest Expenses. But be aware that this percentage wildly varies from industry to industry.
The rule is easy: in any given industry, the company with the lower ratio of Interest Expenses to Operating Income is usually the company most likely to have a durable competitive advantage.
Income before Tax: the number that Buffett uses
Now, after deducting Cost of Goods Sold, Operating expenses and financial expenses we are left with the so-called Income Before Taxes. We are almost at the net earnings but still there is something that the company has to pay, which is the taxes to Uncle Sam. The Income Before Taxes is the value that Buffett uses when he wants to know the Return he’s getting when he buys a whole business or a partial interest of a company through the purchase of shares.
In order to be able to compare businesses of different types, since taxation can be different from country to country, you should always compare pre-tax values. Usually, if you invest in the US Market you can also use the Net Earnings or Net Income after taxes and still it gives you the right information.
After paying expenses and taxes, we are left with the Net Income or Net Earnings. Needless to say, the net earnings are the most important part of the Income Statement because they represent what’s left in the company’s pocket after cashing in the revenue and paying for all the expenses. So, I’ll be short here. Always check the Net Earnings of the last 10 years, for example through QuickFS.net, and look for the following characteristics: The net earnings must have:
- An historical upward trend → Growing net earnings means growing business
- Consistency → So a steady growth of the earnings, not up and down without a logic because that shows that the company isn’t stable.
- A high margin/ratio when divided by the total revenue → this is important because we could have net earnings which look great and grow, but if the revenue is growing much more than the earnings then the company is increasing the expenses too much and it’s not a good thing. Or maybe the net earnings are increasing but the revenue is stable or collapsing and that’s of course also not a good sign.
So, always look for consistency and an upward long term trend of net earnings. Now, there is no magical number but usually, if you divide the net earnings by the Total Revenue and you get a value that is over 30% and is consistent in the last 10 years, then you most likely found a company that has a DCA. If the net earnings are negative, or if the ratio net earnings total revenue is less than 10%, than you most likely found a company that is in a highly competitive market.
Coca cola has a 25% net margin, which is basically stable since 70 years, while airlines have an average of 5-7%, showing how competitive the airline business is.
And last tip about Net earnings: always be careful about Banks and financial institutions: They often have an abnormally high margin of net earnings to total revenue. While the numbers look exciting, that normally means the company is accepting higher investment risks for higher returns, which might have worked well in the past years but can work really bad in the future.
Earnings Per Share
The last parameter we are going to discuss today is a term widely use in the stock market and is the so-called EPS, Earnings per Share. Here in the Income Statement from Coca Cola it’s called Basic Net Income per Share and is nothing more than the total Net Earnings of the company divided by the number of Shares outstanding. So why is it important? If you assume that the earnings of a company reflect the value of the company, or the value that you can get out of a company if you are a shareholder, then the Earnings per Share represents the value that you can get yearly out of every one share you buy. So if you have a company that sells its shares for 50$ and has an EPS of 2$, you can imagine that if you buy 1 share for 50$ each year the company is going to earn 2$ out of your share for you. So it’s going to need 25 years to give you back in Earnings what you paid for the share.
The Earnings Per Share, analyzed over 10 years, can give us a great idea of the presence of a DCA. Now, this is not the calculation you make to see the return of investment of buying shares of a company, but it’s just to give you an idea of the meaning of EPS. What you do look for, though, is a company that has Earnings per share that show consistency and an upward trend. Buffett stays away from companies that have an erratic per share earnings trend, which tells him that the company is in a fiercely competitive niche prone to booms and busts.
So, I hope I could give you an overview of the income statement and of which items are most important to focus on when looking for a good company to invest in. Generally speaking, you should always look for historical consistency and an upward trend in Revenue and Net earnings as well as consistency in all parameters. Always check at least 10 years through QuickFS.net or Yahoo finance and don’t forget to always compare several companies within one industry before investing in one. Remember that each industry works differently and has different typical values of expenses so comparing many companies that work in the same industry helps you get an idea of the benchmark and of which one is performing better.
In the next 2 videos we are going to talk in detail about the other two important financial statements, which are Balance Sheet and Cash Flow Statement.
After you’ll have an overview of all 3 statements you’ll really be able to understand the finance of the companies on a level which is better than most private investors and this will help you make good investment decisions in the long term.
By the way, in the description below I’ll link a summary of today’s video in a one page pdf that you can download for free.
I really hope you enjoyed this content and could find some useful information in it, and if you did please don’t forget to subscribe to my channel and like this video to support my work. Subscribing to the channel and clicking on the ringing bell you’ll also be notified when I’ll publish the parts 3 and 4 of this video series where I’ll talk about the other two financial statements, so stay tuned. So take care, I wish you a great evening, ciao!