Brian Stoffel

Brian Stoffel

27-08-2022

11:56

Capitalism is brutal If you invest, you MUST know how to identify a moat Here are 9 financial “rules of thumb” that Warren Buffett uses to tell if a company has one:

1) Gross Margin Found: Income Statement Formula: Gross Profit / Revenue Moat: Consistently above 40% No Moat: Under 40% & volatile

Buffett’s logic: A consistently high gross margin shows the company doesn’t have to compete exclusively on price It also provides ample gross profit to pay expenses and leaves money for shareholders (dividends/buybacks)

2) Sales, General, and Administrative Expenses Where: Income Statement Formula: SG&A / Gross Profit Moat: Consistently under 30% No Moat: Over 80% & volatile

Buffett’s logic: Wide moat companies don’t need to spend a lot on overhead to operate. No moat businesses do. Buffett looks for companies that consistently spend under 30% of their gross profit on SG&A

3) Depreciation Expense Where: Income Statement & Cash Flow Statement Formula: Depreciation / Gross Profit Moat: Consistently under 10% No Moat: Volatility & high

Buffett’s logic: If depreciation is consistently less than 10% of gross profit, it’s a sign that the company doesn’t need a lot of capital expenditure assets to maintain its competitive advantage and has a moat.

4) Interest Expense Where: Income Statement Formula: Interest Expense / Operating Income Moat: Consistently under 15% No Moat: Over 50% & volatile

Buffett’s logic: Great businesses have such amazing economics they are don’t need debt to grow NB: This number varies greatly from industry to industry. But it’s a great sign if a company consistently spends less than 15% of its operating income on interest

5) Income Tax Expense Where: Income Statement Formula: Income Tax Paid / Pre-tax Income (Earnings Before Tax) Moat: Consistently pays the full amount (~21% in U.S.) No Moat: Negative, erratic

Buffett’s logic: Wide moat businesses make so much money that they are consistently forced to pay their full share of taxes Companies that consistently have negative or an erratic income tax bill aren't as likely to have a durable moat

6) Profit Margin (Net Margin) Where: Income Statement Formula: Net Income / Revenue Moat: Consistently above 20% No Moat: Below 10%, negative, and volatile

Buffett’s logic: Companies that consistently convert 20% of their revenue into net income likely have a moat. If this number is under 10%, negative, or volatile, it's an indication that competition is fierce (There’s plenty of nuance between 10% and 20%)

7) Capital Expenditures Where: Income Statement & Cash Flow Statement Formula: Capital Expenditures / Net Income Moat: Consistently under 25% No Moat: Consistently above 75%

Buffett’s logic: Capital expenditures eat into profits. Companies that don’t have to spend big on capex have more money to reward shareholders Important: Capital Expenditures can vary greatly from year to year. Averaging the result over 10+ years is best

8) Total Liabilities to Adjusted Shareholder Equity Where: Balance Sheet Formula: Total Liabilities / Shareholder Equity Moat: Below 0.80 No Moat: Over 2.00

Buffett’s logic: Wide moat businesses finance themselves with profits, not debt However, stock buybacks can throw off this equation Adjust for this by adding back any treasury stock to the shareholder equity number

9) Return on Shareholders’ Equity Where: Balance Sheet & Income Statement Formula: Net Income / Shareholder Equity Moat: Consistently above 15% No Moat: Below 10%, negative, or volatile

Buffett’s logic: Return on equity shows how effectively management is reinvesting its profits. A number consistently over 15% indicates that the business has a moat Under 10%, negative, or volatile indicates that the business is struggling with competition

3 Important notes: A) These “rules of thumb” are only useful when a company is fully optimized for profits (phase 4) Many of them don’t work at all when a company is in phases 1, 2, 3, or 5

B) CONSISTENCY is key The real test is if a company generates good numbers over multiple years & various economic cycles

C) There are PLENTY of exceptions & nuances to these rules Many of Buffett’s largest holdings do not pass every rule of thumb. That’s because investing & accounting have TONS of nuances Still, rules of thumb are very helpful

Learning to read financial statements is a SUPERPOWER in today's world We can help @BrianFeroldi and I just opened registration for our course: Financial Statements Explained Simply Interested? DM me for a special coupon code (and our largest discount)

Summary: 1. GM >40% 2. SG&A < 30% 3. Depreciation <8% 4. Interest Expense <15% 5. Income tax ~21% 6. Profit Margin >20% 7. CapEx <10% 8. Debt to adjusted Equity < 0.80 9. Return on equity >15%



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