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In Berkshire Hathaway's (BRK.A) 2007 annual shareholder letter, Warren Buffett describes the four key principles he and his partner Charlie Munger use to select investments. For those unfamiliar with the criteria, they are:

  1. A business Buffett and Munger understand
  2. Favorable long-term economics
  3. Able and trustworthy management
  4. A sensible price tag

To help elaborate what Warren meant by favorable long-term economics he introduced the concept of Castles and Moats:

(click to enlarge)

Today I want to discuss a method I developed for identifying companies with deep, wide moats after reading "Warren Buffett and the Interpretation of Financial Statements," by Mary Buffett and David Clark. To help validate and explain my method, I will evaluate Apple, Inc. (AAPL) from 2008 until 2012. I think Apple is a good test for this method since many would agree that the iPhone and iPad, which launched in June of 2007 and April 2010 respectively, were significantly ahead of competition when they first debuted and continue to have favorable advantages over competition. I hope that after reading this article you will bookmark it and consult when considering any future investments.

Methodology

The methodology I have created is founded on two tenets:

  1. Companies with a strong competitive advantage will earn more profit per dollar of sales than those without.
  2. Companies with a strong competitive advantage will be able to use their superior earnings to finance growth and existing operations rather than issuing debt or additional equity.

Based on these two principles, I selected 14 data points to determine if a company has a competitive advantage that creates favorable long-term economics. In my experience, a company will typically meet all the criteria I have set if it has a strong competitive advantage.

Getting Started

In order to start the analysis, the analyst will need to acquire the Income Statements, Balance Sheets, and Statement of Cash Flows of the particular company. Since the analyst is trying to identify a long-term advantage, the more years of the data the better, I would not recommend less than five years of data. For this example, unless specified otherwise, I will be pulling the data for Apple from yCharts.com.

The Income Sheet

There are seven metrics I review within the income sheet in order to determine if there is a competitive advantage:

  1. Gross Margin
  2. Ratio of Selling, General & Administrative Expense to Gross Profit
  3. R&D expense relative to Gross Profit
  4. Depreciation expense relative to Gross Profit
  5. Interest expense relative to the Operating Income (EBIT)
  6. Net Margin
  7. Earnings trend

Gross Margin: The gross margin is the ratio of the company's revenue to profit gross. A company with a strong competitive advantage has the ability to offer its products or services at a higher price point relative to the cost to manufacture than competition. In the case of Apple, it had the first smartphone and tablet to offer individualization through an app marketplace. This advantage allowed it to charge higher prices than competition while still growing share and eventually becoming the market leader.

Typically, gross margins in excess of 35%-40% are a pretty good indicator that the company has a competitive advantage. Below is Apple's gross margin from September 2008 until September 2012:

2012

2011

2010

2009

2008

Gross Margin

40.0%

40.3%

36.9%

41.8%

37.1%

As you can see, the gross margins are right in the 35%-40% window. Just as contrast, consider the gross margins for Southwest Airlines (LUV) from September 2008 until September 2012, which competes in a highly fragmented market and does not have a known competitive advantage.

2012

2011

2010

2009

2008

Gross Margin

21.4%

22.3%

27.5%

19%

20.4%

Ratio of Selling, General and Administrative Expense to Gross Profit: The Selling, General and Administrative (SGA) Expense includes all direct and indirect expenses for the accounting period plus all general and administrative expenses such as advertising, legal fees, employee wages, etc. Consistency is the key when looking at the ratio of SGA expense to gross profit because it shows the company has control over its expenses and can adjust them according to revenue.

The other thing to look at is the absolute value of the percentage. Anything higher than 80% and the company is going to have a tough time rewarding shareholders with growing earnings. I like look for companies that have an SGA ratio of less than 50%. I will still consider companies between 50%-65% but only if the other income sheet metrics discussed are amazing. SGA ratios of less than 30% are fantastic and are a strong indicator the company has a competitive advantage producing favorable long-term economics.

As you can see below, Apple has SGA ratios that are both consistent and low.

2012

2011

2010

2009

2008

SGA : Gross Profit

14.6%

17.3%

21.5%

24.1%

28.5%

Research and Development Expense Relative to Gross Profit: This metric is incredibly important. High R&D expenses indicates that the company is competing in a highly competitive market and must continue to innovate to avoid obsolescence. While patents on a particular technology can offer long-term competitive advantage, they eventually expire and with it the advantage.

Companies that are not dependent on innovation will have R&D expenses that are less than 10% of gross profit. For those with a bit higher risk profile, I think it is acceptable to consider companies with R&D expenses between 10% and 30%, but only if the SGA is 30% or lower.

As you can see, Apple, despite being a technology company, has a ratio of less than 10%.

2012

2011

2010

2009

2008

R&D Expense : Gross Profit

4.9%

5.5%

6.9%

7.7%

8.4%

Depreciation Expense Relative to Gross Profit: High depreciation indicates the company likely competes in a highly competitive, capital-intensive industry. In order for the company to maintain its competitive edge, it has to keep buying new equipment. If the depreciation expense is too high, it can create unfavorable long-term economics.

In looking for companies with a competitive advantage, I want to see depreciation expenses no greater than 10% of gross profit, which as you can see Apple meets:

2012

2011

2010

2009

2008

Depreciation Expense : Gross Profit

0.0%

0.0%

0.0%

0.0%

0.0%

As contrast, if we again look at Southwest Airlines, you can see the depreciation expense relative to gross profit consistently exceeds 20%.

2012

2011

2010

2009

2008

Depreciation Expense : Gross Profit

20.9%

20.6%

27.8%

24.6%

21.1%

Interest Coverage Ratio: The interest coverage ratio is the company's earnings before income and tax (EBIT) to interest expense. A low interest coverage ratio indicates the company has to continue to use debt to finance its operation and stay competitive. Technically, if the company has a strong enough competitive advantage, it should never have to borrow money. The cash generated from the business should be enough to finance growth and maintain existing operations.

Apple is ideal in this sense; the company carries no debt and therefore has no interest expensive. Typically, companies that have a competitive advantage will have an interest coverage ratio of greater than 2.

Net Margin: Net margin is the ratio of net earnings to revenue. Essentially, it answers the question of how much money the company makes for every dollar of product sold. The higher the ratio of net earnings to revenue, the higher the chance the company has a strong competitive advantage.

As a rule of thumb, I consider companies with 20+% net margins to be fantastic, anything between 10%-20% is fair, and anything less than 10% should probably be avoided.

Looking again at Apple, you can see the company has fantastic net margins, with a five-year average of 21.5%.

2012

2011

2010

2009

2008

Net Margin

26.7%

23.9%

21.5%

19.2%

16.3%

Earnings Trend: Companies with strong competitive advantages generate enough cash from existing operations to finance growth, therefore we can expect these companies to have a consistent, upward trend. The key here is that the earnings per share should be consistently increasing. We do not want to see companies with erratic earnings per share or significant losses.

In the case of Apple, per share earnings have grown every for the past five years.

2012

2011

2010

2009

2008

EPS, basic ($USD/share)

44.64

28.05

15.41

9.22

6.94

Balance Sheet

There are six metrics I review within the balance sheet in order to determine if there is a competitive advantage:

  1. Cash
  2. Debt
  3. Receivables relative to Gross Sales
  4. Ratio of Liabilities to Stockholder Equity plus Treasury Stock
  5. Amount of Preferred Stock
  6. Retained earnings

Cash: There is some truth to the old saying, "Cash is king." Companies with a strong competitive advantage generate a lot of cash; often they generate it faster than they can figure out what to do with it. As a result, the cash and short-term investment account tends to grow slowly over time.

One important thing to watch out for is large jumps in cash. This usually means one of two things; the company discontinued an operation or took on new debt.

As for Apple, you can see that the cash and short-term investment account has been steadily growing since 2008.

2012

2011

2010

2009

2008

Cash & Short Term Investments ($B)

29.13

25.95

25.62

23.46

22.11

Debt: Since companies with competitive advantages generate a lot of cash, they tend not to have a use for debt. In contrast, companies without a competitive advantage must carry a large of amount debt because their existing operations do not produce enough cash to maintain current operations and grow the business.

As a rule of thumb, total debt should be less than 4x current operating income.

As stated above, Apple does not carry any debt on its balance sheet.

Receivables Relative to Gross Sales: This metric is especially valuable when comparing two companies within an industry. The ratio of receivables to gross sales helps determine how attractive the terms the company is being offered for its product or service. Companies with a competitive advantage will often have a lower ratio than the industry because their advantage allows them to demand better terms than competition.

Ratio of Liabilities to Stockholder Equity plus Treasury Stock: Companies with a competitive advantage tend to finance operations and growth with earnings generated by the business. In contrast, companies without a competitive advantage tend to use debt to finance growth. As a result, the ratio of liabilities to stockholder equity plus treasury stock tends to be higher for companies without a competitive advantage.

For most companies I look for a ratio of liabilities to stockholder equity plus treasury stock of less than 80%. However, banks present a special case due to the large amount of debt they keep on their balance sheets. For banks, I like to see the ratio less than 10.

For Apple, the ratio is consistently less than 80% with a five-year average of 54.1%

2012

2011

2010

2009

2008

Liabilities : Stockholder Equity + Treasury Stock

48.9%

51.9%

57.3%

50.1%

62.2%

Amount of Preferred Stock: Preferred stock is an expensive way to raise money. Essentially, preferred stock is very much like issuing a bond with a fixed interest rate; the catch however is that the interest is not tax deductible. Since companies with a competitive advantage tend to be self-financing, they rarely have a need to issue preferred stock.

As you might have guessed, Apple does not carry any preferred stock.

Retained Earnings: Companies with a competitive advantage produce more than enough cash to operate and grow their business. As result, the retained earnings section of the balance should be continually growing with time.

Companies with a competitive advantage tend to have an average growth rate of at least 7% over the period with no unexplained declines.

In the case of Apple, the average growth rate in retained earnings from 2008 to 2012 was 61%.

Statement of Cash Flows

The statement of cash flows only has one metric of particular interest in determining if a company has a competitive advantage, the ratio of capital expenditures to net earnings. The ratio of capital expenditures to net earnings is useful because it measures how much money the company has to re-invest into assets every year to stay competitive. For the most part, companies with a competitive advantage do not have to re-invest much to stay competitive.

I view any company with a ratio of less than 50% as good and anything less than 25% as excellent.

As you can see from the table below, Apple falls into the excellent category with a five-year average of 9%.

2012

2011

2010

2009

2008

Capital Expenditures : Gross Profit

12.1%

9.7%

7.8%

6.6%

8.3%

Conclusion

Companies with a competitive advantage are able to produce enough earnings from their products/services that they are essentially self-financing. Using the 14 metrics described above, an astute investor can determine if a company has a competitive advantage that produces favorable long-term economics, based solely on financial statements.

By analyzing Apple during a period in which the iPhone and iPad were definitely acting as competitive advantages for the company, we were able to validate the methodology's ability to identify companies with a competitive advantage.

Finally, please remember this methodology should not be the only criteria you check before initiating an investment. This methodology only helps to identify companies with a competitive advantage; it does nothing to gauge your understanding of the business, the strength of the management, or the current price tag of the investment. These criteria must be evaluated before any long-term investment is initiated.

Source: A Method For Investors To Identify Companies With Competitive Advantages