BUFFETTS BOOKS ACADEMY: INTERMEDIATE COURSE
LESSON 18: WARREN BUFFETT’S 1ST RULE – INVEST IN VIGILANT LEADERS
LESSON OBJECTIVES
- Define what a vigilant leader is.
- Understand the Debt to Equity Ratio.
- Understand the Current Ratio.
- Understand what levels of debt are acceptable.
LESSON SUMMARY
In this lesson we learn about the very first rule of Warren Buffett: “A stock must be managed by vigilant leaders”. What that means is that the leaders should be observant and attentive. They should always be on the lookout for danger. In business life there is no greater danger than not being able to meet you debt obligations. If case that happens creditors can claim liquidation of the company.
Related Resource: Podcast discussion on Warren Buffett’s Rules to Stock Investing.
For this reason you want a leader who is managing your company, and is making sure that no dangers occur. A leader of a company will typically look at the two key ratios: Debt to Equity Ratio and The Current Ratio. As an investor you can check the vigilance of the leaders by looking up those two key ratios yourself.
Debt to Equity Ratio can easily be explained. First add up on the debt that you have. Say that is $20,000 in total. Then add up all the equity you have. So that is the net value of your personal assets. I could be you home, car, furniture, and so on and subtracting the debt you have incurred in those asset (like mortgage and car loan). If that turned out to be $100,000 you would have a Debt / Equity of = $20,000/$100,000 = .20. For comparison Warren Buffett likes a Debt / Equity below .50. In other words for every $10 of equity he only allows the debt to be $5.
All providers of financial information have Debt to Equity available on their homepage. An example of a provider could be MSN Money, Morningstar, Yahoo Finance and other free services.
What the providers of financial information are doing is pulling information of the balance sheet. For the equity the calculation is very simple: Assets – Liabilities. When identifying the debt it is not the same as liabilities. You need to look at the balance sheet and add up all the lines that has debt in it. There are people who do the Debt / Equity calculation using all liabilities as debt, and clearly that would give another number. But Warren Buffett likes to look at the first method, and that is where you have your rule of thumb with Debt / Equity that should be below .50.
One thing that is important to remember when working with debt is that every investor appetite for risk is different. In any case you should go with the level of debt that you feel comfortable with. Luckily you do not need to do the calculation. The provider of financial information has always calculated it for you, and is typically disclosed on the front page for a given stock.
Current Ratio is another very important key ratio to be familiar when monitoring if the leaders are vigilant. What the current ratio is measuring is how well the company handles debt in the next 12 month. This is done by comparing the current assets with the current liability. Another way of seeing that is to compare how much cash is coming in the next 12 month (current assets), and how much cash is going out the next 12 month (current liabilities). Warren Buffett likes a current ratio above 1.50. That means for every $10 that is going out on cash, $15 should be a cash inflow.
This calculation can be pulled off the balance sheet. Current assets and current liabilities are actually grouped nicely for you when you look at the balance sheet.
Just as for Debt / Equity the current ratio is typically listed on the front page, already calculated for you, when you pull up the information for a given stock. As with the Debt / Equity the exact threshold for when you think a current ratio is sufficient is very independent.
NEW VOCABULARY
Debt to Equity Ratio
Sometimes known as (Debt/Ratio). This key ratio is comparing the debt to the equity in the company. Warren Buffett prefers a company with a debt to equity ratio that is below .5. In other word for every $10 in equity the company should only have $5 in debt.
Current Ratio
This key ratio compares how much cash is expected to be converted to cash in the next 12 month (current assets), to how much cash that are expected to flow out (current liabilities). Warren Buffett prefers a ratio above 1.50. In other words for every $15 in cash inflow there must not be more than $10 in cash outflow.
Current Assets
This measure is indicating how much cash that is expected to flow into the company the next 12 month. Current assets includes among many different accounts: inventory, people that owe you money, and cash itself.
Current Liabilities
This measure is indicating how much cash that is expected to flow out of the company in the next 12 month. Current liabilities include among many different accounts: Suppliers that you have bought on credit from, rent, expenses where you have used the service, but not paid.
LESSON TRANSCRIPT
From the previous lesson, you learned that there are the 4 rules. The focus for this lesson is “A stock must be managed by vigilant leaders”. “Vigilant” means to be carefully observant for possible danger. If you have a company managed by a vigilant person, that person is constantly looking for what could go wrong with the business and thus protects the business from potential danger.
What are the potential dangers when managing a company? As an owner of a company, you really need to watch out for debt. This is the focus of Warren Buffett’s first rule.
There are two quick tools for determining acceptable level of debt for a company:
- Debt to equity ratio
- Current ratio
These are important things to understand when investing. If this isn’t something you’ve even done before, I suggest that you take notes during this lesson and learn both these ratios really well.
We’ll start off with the debt to equity ratio studying two companies – Walt Disney and Sirius Satellite Radio – to give you a comparison of how these look with their debt to equity ratio. As we move forward, you can find the different terminologies off the balance sheet.
Just a quick overview of what a debt to equity ratio is. Equity is the money left after adding up everything you have and subtracting your total debt from there. Compare that debt to the equity by dividing the debt by the equity.
Let’s go to the two companies that we would assess and look at their debt to equity – Disney and Series FM Radio. Go to MSN.com (I’m just using MSN because I know where all the terms are at on this site, so that could navigate a little bit faster). Find the area where to input a stock quote. We will look at Disney first. Put in D-I-S and hit enter to bring you to all the information in the Walt Disney Company. The debt to equity ratio is on the very top page. Disney’s debt to equity ratio is .42. Again, Warren Buffett wants to buy companies that are below .50. Disney fits that criterion.
How do you find that .42? Pull that number from the balance sheet found at the left of the screen. Now, there are two options at the top – annual and interim. Click interim, because it has the most current information. We’re looking at the second quarter of 2012 where the balance sheet is broken down into two major groups – assets and liabilities. The difference between the two is the equity.
When you take the total assets, 75 (75 billion because the numbers are in billions), you subtract the total liabilities, 37 billion dollars. You will get the total equity of 38 billion dollars. To calculate the debt to equity ratio, go to the balance sheet and to the liability section and look for anything with debt.
You have another thing that says debt. Take the 3 billion dollars. Add this total long term debt of 12 billion. Add up those terms that have debt attached to them in the description. It gives you both 3.4 billion and 12.5 billion. Add those 2 numbers and divide by the total equity.
We will look at this real fast. You’ve got 3.4 plus 3.5 and 3.5 plus the 12.5. That will give you your 16 flat. Take 16 divided by 38 to give you .4 and some change that we saw with the debt to equity ratio. That’s the way to calculate it, especially if you will quickly go through and asses a company. The number on the top is probably pretty close to what is current.
Another way to look at the debt to equity ratio is by comparing all the liabilities to the equity. In this case, you’d see it’s almost 1.0, because you’ve got 37 billion compared to a 38 billion. That number is just slightly under 1.0, which is a little bit of a higher estimate. If you’re more of a conservative investor, take this approach instead of taking the debt terms inside of the current liabilities and the total liabilities. I recommend a more conservative approach which is your beginning. As you get a little bit more comfortable, you can see how conservative you are on your approach.
For Disney, we saw that the debt to equity ratio was a .42, which is a pretty conservative amount of debt. Disney should be able to easily pay those debts at that ratio, because they have enough income coming in order to support it.
Let’s look at the Sirius Satellite Radio. Type S-I-R-I. Look at their debt to equity ratio. The process is exactly the same as what we did with Disney. The debt to equity ratio for Sirius Satellite Radio is 3.48, which is extremely high. The easiest way to understand the ratio is $3.48 is debt for every $1 of equity in the business. Whatever the ratio is, that’s always over 1 dollar of equity. This company has a lot of debt right now. Don’t even plan on investing in this company and go any further to calculate the intrinsic value, because it has way too much debt.
Now that might be way too conservative for your approach, but that’s something you have to come to terms with and come up with on your own. For me, I like to look at companies that are well below the .5. There are many companies out in the stock market right now that has 0, because they literally have no debt. Why would I go to a company that has lot of debt? It has a lot of risks. Whenever I can buy something else with no debt, it has better earnings.
That’s the debt to equity ratio – the first tool to assess whether you have vigilant leaders leading companies. Let’s go back and check out our next tool which is the current ratio.
Like before, we’ll use Disney and Sirius again to assess the current ratio. The current ratio gives us an idea on how the company will handle debt in the next 12 months. The debt to equity ratio in the last scenario was just a general overview of all the debt added up and comparing it to the equity the company has.
In this scene, we’ll look at how much money the company expects to come out in the next 12 months and how much they have to pay in the 12 months. Through this, we can determine how much debt potentially this company will have to take on if they have to take on any debt at all. When we look at the current ratio, Warren Buffett likes the current ratio above 1.5.
We’re back at MSN Money with Walt Disney at the top level page. Just follow the same technique as we used before. Type D-I-S to get to the Walt Disney Company. Go back to the balance sheet again to determine the current ratio. Unfortunately, the current ratio is not listed anywhere on this top level page, so go to the balance sheet and assess. Click on balance sheet which was just down on the financials and don’t forget to choose interim. The balance sheet has the assets broken down into two sections – total current assets and total assets. When a company lists something in the total current assets, this means they likely convert whatever that is into cash during next 12 months. 14 billion dollars in total current assets is converted to cash in the next 12 months.
Likewise, when you go down into the liabilities, it’s broken down into two sections – total current liabilities and just total liabilities. The total current liabilities is what they pay out of the company in the next 12 months. This is 12 billion dollars which is lower than the 14 billion dollars that they have flowing into the company. That’s a good thing. Basically, the current ratio is about taking the top number which is the money flowing in and dividing it by the money flowing out. That’s short-term, 12 months.
If this was 14 billion and this was 14 billion, the current ratio would be a 1.0. All the money flowing in is exactly the same money flowing out. There’s no change in your equity. In this scene, we see that the total current assets exceeds the total current liabilities. To figure out the current ratio, take 14.5 divided by 12.7.It’s simple. Take the full number divided by this full number. When you take those and divide them, you get 1.14.
Again, Warren Buffet likes to buy companies with current ratio above 1.5. In this case, Disney’s current ratio is 1.14, which is a low figure and still above the 1.0 which is really your absolute cut off. It’s above the 1.0 mark, but not as high as the 1.5 level. On the stock market right now, you can find companies that have current ratio over a 2.0 or a 3.0. We’re looking for a company above 1.5 and maybe around 2.0. This is still acceptable.
If you’re really interested in buying Disney, maybe this is something you would go ahead and take the risk on knowing that it’s pretty close to 1.0.
Let’s go ahead and look at the Sirius Satellite radio.
Type S-I-R-I. Hit enter. Come down to the financial section. Click the balance sheet. Make sure you’re on interim. When we look at the number, it’s 1.3 billion and the liabilities further their total current liabilities, which they’ll have in 12 months is 2.2 billion. Take the top number divided by the bottom number to get a current ratio of .597 (round off to .6). That is something to avoid at all costs, because it’s below 1.0. Based on that, they’ll have to take on more debt in the next 12 months.
In this lesson, students learned the importance of investing in vigilant leaders – a manager that won’t put your business in dangerous situations.
Right now, many businesses around the world manage their debt very poorly. The best way to identify these types of businesses is through the two tools you learned in this lesson; the Debt to Equity Ratio and the Current Ratio.
The Debt to Equity ratio is found on the balance sheet. To calculate the number, simply divided the total debt by the equity to give you the ratio. This ratio is very important because it shows a potential owner (or shareholder) how much leverage a company has on its business. The lower the ratio is, the better for you as an owner. When Warren Buffett invests in stocks, he typically likes to find debt to equity ratios that are lower than (0.50).
The Current ratio is also found on the balance sheet. To calculate the number, simply divided the current assets by the current liabilities. The Current assets are the cash or other assets the company will likely convert to cash during the next 12 months. Likewise, the current liabilities are the debts that the company must pay in the next 12 months. By comparing these two figures, a potential owner gets a great idea if the company will need to incur debt within the next 12 months. If the current ratio is a 1.0, that means the company’s current assets and liabilities are equal. A number lower than 1.0 is bad and it means the company will most likely incur debt within the next 12 months. A number above 1.0 means the company’s assets will exceed the liabilities. This is a good thing and what you want to find in a business.
When Warren Buffett looks for a company to buy, he always tries to find a company with a current ratio above 1.5.