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Buffett on Financial Statements: Balance Sheet, Shareholders' Equity

- By Robert Abbott

For most investors, including Warren Buffett (Trades, Portfolio), the shareholders' equity section may be the most important section of the balance sheet.

In previous chapters of "Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage," authors Mary Buffett and David Clark outlined what the guru looks for when studying the income statement and the asset and liabilities sections of the balance sheet.

Next, they turned their attention to the final piece of the balance sheet. This excerpt from the book shows a typical shareholders' equity statement:

As we see, the section begins with total equities and that reminds us that liabilities and equities are shown together because in total they equal the total of assets. The sheet is balanced with assets on one side and liabilities plus shareholders' equity on the other.

Or we can subtract total liabilities from total assets and arrive at the amount of shareholders' equity. That amount also may be called a company's "net worth." All different ways of saying how much shareholders invested in the company, plus how much of earnings has been left in to operate and grow it.

Common and preferred stock

The basic form of shareholders' equity is common stock. It provides an ownership stake to public investors and never has to be paid back. In exchange for turning over their capital, shareholders get to elect a board of directors and the board hires a chief executive officer to manage the company on their behalf.

There are also investors who contribute their capital but do not receive voting rights. These are the holders of preferred shares and in exchange for the contribution without voting rights, they normally receive a fixed dividend that must be paid before dividends can be distributed to common shareholders. They are also higher in the pecking order if a company goes bankrupt.

From Buffett's perspective, the fewer the preferred shares, the better. Companies with durable competitive advantages, or moats, usually don't carry any; "they make so much money that they are self-financing." That's because preferred shares function like debt; their dividends must be paid, and because they are quite expensive instruments for financing.

Paid in capital

There may be a difference between the price at which a company carries stock on its book, the "par value," and the price at which it sells those shares. For example, a company might carry common stocks on its books at $1, the par value, but sell them to the public for $10. The $9 difference between the two constitutes "paid in capital."

Retained earnings

The authors subtitled this chapter "Warren's Secret for Getting Superrich" to signal its importance. A company's net earnings can be distributed as dividends or buybacks. Any funds that are left after these are paid goes into an account on the balance sheet called "retained earnings." The more that can be retained and channelled into growth, the faster the company will grow. For example, Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) paid no dividends and bought back no shares between 1965, when its share price was $19, and 2007, when the price was $78,000 (that is $78,000 per share for Class A stock).

Determining the amount that a company held in retained earnings can be found by subtracting the cost of dividends and buybacks from its after-tax net earnings. For example, Coca-Cola (KO) earned $5.9 billion in 2007. It then paid $3.1 billion in dividends and buybacks, leaving $2.8 billion to be added to retained earnings.

Buffett wants to know if a company is making additions to its retained earnings. The authors wrote, "Simply put, the rate of growth of a company's retained earnings is a good indicator whether or not it is benefiting from having a durable competitive advantage." Here are some of the rates of growth of retained earnings for the years prior to 2008 (when this book was published):

  • Coca-Cola: 7.9%.
  • Burlington Northern Santa Fe Railway: 15.6%.
  • Anheuser-Busch (BUD): 6.4%.
  • Wells Fargo (WFC): 14.2%.
  • Berkshire Hathaway: 23%

For contrast, consider the cases of Microsoft (MSFT) and General Motors (GM), both of which have negative retained earnings. Microsoft was not growing its retained earnings because it was an economic powerhouse and immediately used or distributed its retained earnings to shareholders; General Motors was not growing its retained earnings because it was not making money.

As noted, Berkshire Hathaway is one of the companies that held on to its retained earnings. Buffett reinvested those earnings in other companies that were growing and enjoyed the fruits of compounding. In the authors' words, "Berkshire is like a goose that not only keeps laying golden eggs, but each one of those golden eggs hatches another goose with the golden touch, and those golden geese lay even more golden eggs."

Treasury Stock

Continuing down the lines of the shareholders' equity section, treasury stock is the next line item after retained earnings. This refers to common stock that a company bought back but has not canceled. If canceled, the shares completely disappear, as if they were never there. But a company may not cancel them if it thinks it might reissue them in the future.

According to the authors, a company with lots of treasury shares may have a durable competitive advantage and enough cash to buy back a lot more common shares. In other words, a negative balance on the Treasury stock line may signal a potential winner.

Total shareholders' equity

This is the end result of the shareholders' equity portion of the balance sheet. It equals the amount of preferred and common stock, paid in capital and retained earnings, less the amount of treasury stock.

It is also the basis of a ratio in which Buffett takes a close interest: return on shareholders' equity. Generally, companies with durable competitive advantages tend to have above-average returns on shareholders' equity. Some examples, from years prior to 2008:

  • Coca-Cola: 30%.
  • Hershey's (HSY): 33%.
  • PepsiCo (PEP): 34%.

The authors again turn to the highly competitive airline industry to find companies with weak returns on shareholders' equity:

  • American Airlines (AAL): 4%.
  • Delta Air Lines (DAL): 0%.

From an analytical perspective, companies generating high returns on equity are successfully managing the earnings they retain. As the earnings go up, the company's valuation and share price should also rise.

We are reminded by the authors that some companies, such as Microsoft, do not need to retain earnings because of their high profitability.

They also remind readers of the effects--and dangers--of leverage. In generating returns, debt may mimic stock and make a company look stronger than it is. As this book was written just before and during the 2008 financial crisis, the authors were quite aware of the damage done to Wall Street investment banks by too much leverage. This is one more reason why Buffett stays away from companies with too much of a debt load.

In summary, the shareholders' equity section of the balance sheet has much to divulge to investors who seek companies with durable competitive advantages.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.