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The Essence of Buffett's Performance
At the 2025 Berkshire Hathaway shareholders meeting, investment guru Warren Buffett announced his retirement as CEO by the end of the year and recommended Abel, his chosen successor, to take over. Although the legendary investor is retiring, his advocacy for long-term investing, rational decision-making, and value discovery will remain influential, continuing to guide generations of investors.
This article outlines key metrics from Buffett’s focus on financial statement analysis, organized across the three main financial statements, serving as a reference standard for stock selection in daily practice.
Income Statement: Identify ‘cash cows’ with high gross margins, low expenses, minimal R&D spending, and stable tax rates.
Balance Sheet: Favor ‘fortress-like companies’ characterized by low debt, high ROE, and abundant cash reserves.
Cash Flow Statement: Focus on ‘compounding machines’ with robust free cash flow and low capital requirements.
Section One: Income Statement – Identifying Profitability and Operational Efficiency
Gross Margin: Gross margin reflects the profitability of core operations. Companies with margins exceeding 40% often possess pricing power or cost control advantages (e.g., Coca-Cola). Prioritize firms with consistently high or rising gross margins, while being cautious of significant fluctuations.
Selling and Administrative Expenses: A low expense ratio (<30%) indicates efficient management and a strong brand moat (e.g., See's Candies). Compare industry benchmarks and be wary of companies with continuously rising expense ratios.
R&D Expense Ratio: High R&D spending (e.g., technology companies) may weaken long-term competitive advantages due to technological iteration risks. Prefer companies that rely on branding or business models rather than R&D (e.g., Coca-Cola).
Depreciation Expense Ratio: A low depreciation rate (<10%) suggests asset-light operations, with minimal pressure for capital reinvestment (e.g., service-oriented businesses). Be cautious of heavy-asset industries (e.g., airlines) where high depreciation erodes profits.
Interest Expense Ratio: An excessively high proportion of interest expenses (>15%) reflects debt risk and may weaken the ability to withstand economic cycles. Prefer companies with an interest coverage ratio (EBIT/interest) exceeding 5x.
Effective Tax Rate: An abnormally low tax rate may indicate reliance on short-term policy incentives, raising questions about sustainability. Focus on long-term consistency between the company’s tax rate and the industry average.
Net Profit Margin: A net profit margin exceeding 20% with strong sustainability indicates that the company possesses multiple competitive advantages (e.g., Apple). Analyze in conjunction with gross margin to exclude distortions from one-time gains.
Earnings Per Share Growth Rate: Steady growth (annual average of 10%+) is more important than short-term spikes, reflecting intrinsic momentum. Validate trends using a rolling five-year dataset and remain vigilant against accounting manipulation.
II. Balance Sheet: Evaluating Financial Health and Capital Structure
Return on Equity: An ROE exceeding 15% with minimal volatility indicates efficient capital allocation (e.g., Moody's). Decompose into net profit margin, asset turnover, and equity multiplier to identify key drivers.
Cash and Debt: Positive net cash (cash - debt > 0) serves as the company's "oxygen tank" for risk resistance. Prioritize companies with free cash flow sufficient to cover short-term debt.
Debt-to-Equity Ratio: A low leverage ratio (<0.5) reduces bankruptcy risk during economic downturns. Compare against industry characteristics (e.g., utilities may allow higher leverage).
Retained Earnings: Continuously growing retained earnings reflect reinvestment capability (e.g., Berkshire Hathaway). Assess in conjunction with ROE to evaluate reinvestment efficiency and avoid capital wastage.
Preferred Shares: Preferred shares dilute common stock equity and may obscure true debt levels. Reassess financial leverage by including preferred shares as part of total debt.
Treasury shares: Repurchasing shares can enhance per-share value, but the reasonableness of the price must be assessed. Pay attention to companies that cancel repurchased shares rather than using them for option incentives.
III. Cash Flow Statement: Examining the quality of earnings and capital requirements
Capital expenditure ratio: Companies with capital expenditures / net profit <50% are more likely to generate free cash flow (e.g., software companies). Be wary of profit traps in industries with high capital spending (e.g., automobile manufacturing).
By tracking these indicators across cycles, investors can identify companies with genuine economic moats and avoid the pitfalls of short-term financial embellishments. Buffett's essence lies in using financial statements to verify business models, not to predict the future.
For more content on Buffett's investment strategies, fellow investors can click here to continue learning >> Investment Masterclass: Warren Buffett》
