In order to start developing your star list of great companies, I want to do a series which gives you the tools you will need to screen and vet companies for your list. To do this, you will rely on analysis of the income statement, the cash flow statement, and the balance sheet. These key statements for a company are critical to learn how to read.
Keep in mind that no single number tells you everything you need to know about a company. Each number is like a sentence in a story. In isolation, you don’t have the full picture. However, just like sentences combine and interact to tell the story, the numbers in these statements interact to tell a story, and as you become more proficient with this, you can read the story. I say this because there is a tendency for people to try to screen stocks by one or two measures in isolation (such as debt to equity, or price to earnings, for example). To use these numbers in isolation without any context is not what you want to be doing. Each of these measures tells only one incomplete part of the story, and can even lead you to the wrong conclusion in some cases.
So, we are going to analyze an example of a great company – the Coca Cola company. We will start off with the income statement in this post, and in subsequent posts move to the cash flow statement and the balance sheet. Because these statements interact with each other, we will use the statements that we covered in earlier posts to augment our analysis. Finally, once we finish, we will analyze fully a less desirable company so that you can see the important distinctions in building your shopping list of outstanding companies. Remember, we want to build a list of great companies first, without regard to current valuation. We want to have our companies identified and ready for purchase when they go on sale. A particular company may only go on sale once a decade or less. But once it does go on sale, we are ready to pounce and purchase a great company at a great price. The purpose of this series therefore, is not to do a valuation analysis, but to do the initial identification and vetting of a company. There is more to do after this initial screening to make sure there are no other qualitative risks present that don’t show up in the numbers, some of which we covered in a previous post. So without further ado, let’s dive into the analysis of the income statement of the Coca Cola company.
Table 1 lists the numbers from the income statement for the Coca Cola Company from the last completed 11 years. You can find these on the SEC Edgar website in the 10-k document for each fiscal year. You can also usually find them on the company’s investor relations website. Table 2 lists some figures of merit for the Coca Cola Company that we will calculate from these numbers and talk about in the discussion below.
The figures I want to look at first are revenues and cost of goods sold. Revenues are money brought in from sales of the company’s products. More specifically it is money brought in from sales of the core business of the company (profits from non-core items should be reported as gains elsewhere). This number should always be positive and not zero. If it is zero for one or more years, it usually indicates a new company or a pre-revenue company. We are not interested in those types of risky investments. We are only interested in tried-and-true companies that have a long track record of consistent performance for building our star list.
Cost of goods sold is the set of costs associated with direct production of the company’s core goods (labor and materials usually). Gross profit is a figure we will calculate from this which is given by the following formula:
Gross Profit = Revenue – Cost of goods sold
We are interested in gross profit because we want to calculate the gross margin which is given by:
Gross Margin = Gross Profit / Revenue
The reason why we are interested in gross margin is twofold. One, is that revenue and cost of goods sold are figures that are very hard to fake or manipulate on the income statement without committing outright fraud, which risks prison time for anyone attempting it. We are always interested in these kinds of measures. Other numbers like earnings have a lot of grey areas for manipulation, whether deliberate or not. So, profit margin (Profit Margin = Earnings / Revenue) is more easy to manipulate than gross margin.
The second reason we are interested in gross margin is that it can tell us about the core economic engine of the business in a meaningful way. As we look at Coke, do we really care if they sold a piece of real estate last year and made a huge gain? Not really for star list identification, since the real estate sale is a one time gain and not their core business. We care about the ability of their core economic engine to generate cash, since that is the engine that will be running for the next 100 years to make us money as investors. We want to look under the hood and strip out the extraneous stuff and know if Coke has a viable business model. Gross margin helps us look at just that.
Warren Buffett has said that any company with a gross margin above 40% probably has got a monopoly or a business with a “moat” around its proverbial castle protecting it. I generally like to see gross margins above 25% without exception for the companies that go on my list, and preferably above 40%. It is okay to go a bit below 40% when the company has a lot of other things going for it. This is especially true when virtually all of the gross margin translates directly to operating margin and profit margin with few expenses reducing this further. In that case we can possible accept slightly lower gross margins because the business is a very efficient machine at translating sales into profits with few extra expenses taking a bite out of things along the way.
Keep in mind the type of stock when you are looking at some of these measures. Context matters. Gross margins will generally be lower for companies that make physical products. Gross margins will generally be higher for companies that create ideas or software that scale easily without the need to make a physical product (i.e., have a low cost of goods sold). Instead, those companies may have higher indirect labor costs (sales costs for example), which come out further down in the income statement from gross profit. A gross margin of 50% would be low for a bank, but high for a toy manufacturer for example. Nevertheless, I would stick with desiring a gross margin that is high overall, and high for the industry of which the company is a part.
If we do a quick calculation for Coke over the last 11 years, we see that gross margin is about 60%, which is excellent. This is pretty stable too. Great companies tend to have more stability in their numbers such as cash flows and gross margins than poor companies as a general rule. Also note, that it can indicate problems, if gross margin is consistently deteriorating over time.
Next we want to look at operating income. Operating income is gross profit minus normal operating expenses for the core business (such as wages, supplies, utilities, sales costs for the products, etc.). Again this is the profit that the core economic engine of a business produces before subtracting other non-core items like income from the sale of a piece of real estate as mentioned above. Operating margin can similarly be calculated as
Operating Margin = Operating Income / Revenue
This is like a pre-tax margin on the core economic engine of the business. I like to see operating margins that are also high. 20% or more would be considered good, but lower can be justified depending on the overall situation of the company. Again, if the company is very efficient at translating operating profits into earnings (i.e., profit margin is not much lower than operating margin) it can be acceptable to relax this number a bit. For Coke, the operating margin is around 24% and fairly stable which is good.
When profit margin is very similar to operating margin, which is in turn very similar to gross margin (hasn’t reduced much), it can tell you that the company has good efficiency to translate revenues into profits without a lot of expenses to reduce profits. If on the other hand, operating margins are wildly different than gross margin and seem to move in different directions each year from gross margin (i.e., gross margin deteriorates but operating income improves) you will need to dig into the numbers to find out exactly why. It could be a perfectly legitimate temporary reason or it could be due to a problem or earnings manipulation. Again, the best companies are consistent more often than not.
Similarly, profit margin, which was already mentioned above, can be calculated as
Profit Margin = Earnings / Revenue
Profit margin for a good company should generally be above 10% on a long term average. There are a small number of notable exceptions – companies that do massive volumes of sales and run so efficiently and have so much brand power or recession resistance, that they do not need such a large cushion for things going wrong. However, for most companies, you will want to have such a cushion.
Be aware that profit margin is more easily manipulated because earnings are more easily manipulated. I would recommend looking back through at least 10 years of data for all of these measures, but especially for profit margin, since it is harder to manipulate earnings for a longer time period. You also want to analyze the company over a complete business cycle which typically lasts 7-10 years. Coke again demonstrates great consistency here. Earnings are very stable with an excellent profit margin of around 19% on average. As you can see, the profit margin for Coke (19%) hasn’t reduced much from operating margin (24%), and on average the profits are about 80% of operating income. This amount is very stable over the 11 year period analyzed which shows that Coke is able to control expenses and translate revenues into profits efficiently.
Next, we want to look at a figure called interest coverage. Interest coverage is the number of times that the company can cover interest on its debt service with profits. Traditionally, this figure is calculated using the following:
Interest coverage = Earnings / Interest expense
I use that figure, but I also use another figure for interest coverage
Interest coverage alternate = Operating income / Interest expense
The reason I care about this is if there are large repeated one time gains by management that are sustained over a number of years, it can make earnings look bigger than operating income, which probably cannot be sustained forever. Sometimes managements manipulate earnings by holding onto a past large gain and slowly recognizing it over time to make earnings look good, even though the company has long since burned through that gain.
I actually want to know that the economic engine of the business alone can service the company’s debt load. It is generally recommended that the traditional interest coverage is no lower than 2, and I generally like to see interest coverage based on operating income at above 3-4 to provide a safety cushion against defaulting on debt. Coke’s interest coverage based on operating income is at a very healthy 11.5x. That is, Coke’s economic engine is more than able to service the interest on its debt with the cash it produces.
Finally, we want to look at weighted average diluted and non-diluted earnings per share. Looking at several years of data, what does the share count look like? Is it increasing a lot? If so, was that because the company made a great purchase that added to it’s ability to earn or is it because the company is issuing a lot of shares to management? Diluted share count is the amount of shares that would be present if all of the stock and options were vested and granted for employees and management. If diluted share count is more than 5-7% higher than regular share count it indicates that management is being very generous with their compensation package using stock and options. This can be justified when there is an outstanding management team and the company is growing, but often it just indicates excessive stock compensation. If the company touts share buybacks but the diluted share count is staying the same or increasing, then management is issuing even more options and stock than the buybacks are taking out of the system, so the buybacks are effectively going into management’s pockets. I like to see companies which consistently reduce share count, which can indicate a good management team. Having increasing share count doesn’t eliminate a company from my list, but if that happens, I am on the lookout for whether the increasing share count is for good reason or not. If it is going to management bonuses, the management team had better be doing an outstanding job which translates directly into improving company metrics every year and which more than offsets the additional expense.
In the case of Coke, we can see that the diluted share count has decreased by 3.8% over the last 11 years. In other words, without purchasing any additional shares of Coke over the last 11 years, a shareholder now owns 3.8% more Coke. Further, the share count and the diluted share count are almost the same – there is hardly any dilution. This means that Coke is treating its stock as precious and is not being overly generous to management, preserving investors’ value over time.
As you look through the numbers, remember as I said above that great companies tend to be much more consistent than poor companies. While not always the case, it is usually rare that a great company will have revenues bouncing all over the place or negative operating income. A great company may have a period of time or an occasional year where there is some issue that eventually gets resolved, but otherwise, it should have a pretty good track record.
In the next post, we will analyze the cash flow statement. We will also use these income statement figures together with the cash flow statement to further examine earnings quality and calculate other figures of merit.
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