1 Three Dominant Thought Streams (modes of ego consciousness)

Sab apni film ke hero hain

1.1 Orientation towards material objects

Attitute towards human resource:
Attitude towards other material resources:

1.2 Range of Perspective (Gaze)

Awareness of consequences of actions:

1.3 Task (Process) Orientation V/s Outcome (Goal) Orientation

2 SubConscious Tendencies ( Divine / Superego vs Demonic / ID )

Chitta is like subconscious lake, though streams are like waves, indweller is the bottom
Connecting tamasik pleasure (mooldhara) with satvik gaze (saharsara) leads to enlightenment (equani
Usually the people are same as their thought streams
Intuitive vision that tells you how to position yourself no matter what material combination

2.1 Irritability (versus Equanimity)

Gladness towards virture and indifference towards vice, makes mind pure
Mental equanimity may be gained by the even expulsion and retention of energy (control breath to
One pointedness is the steadfastness of the mind
Yoga is the neutralization of the vortices of Chitta
The one pointedness of the Chitta is when it grasps in one, the past and present.
A balanced breathing leads to a balanced vision

2.2 Seperation (versus Oneness)

The mastery of one in Union extends from the finest atomic particle to the greatest infinity.
The means of perfecting the posture (asana) is that of relaxing or loosening of effort, and allowing a
This entire
Knowing perceived world
differentiatedly is Yogi's own
is bondage self,knowing
and not or His own
un-body is just like an object to him
differentiatedly is bondage

2.3 Control (versus Detachment)

Thought-streams are controlled by practice and non-attachment
Attachment is that magnetic pattern which clusters in pleasure and pulls one towards such experien
Aversion is the magnetic pattern which clusters in misery and pushes one from such experie
Desire for never ending life is beginningless
For identificaiton of the true self (drashtu) with that which is mutable is the cause of suffering.
Attachment - Desire - Anger - Loss of discernment - Suffering
 Thirst for happiness being eternal, desires are without beginning
Impressions and desires are bound together. In the absence of the latter the former too ceases to e

2.4 Hedonism (versus Self control)

Desirelessness towards the seen and the unseen gives the consciousness of mastery
Self-restraint in actions includes abstention from violence, from falsehoods, from stealing, from s
From purity follows a withdrawal from enchantment over one's own body as well as a cessation o
When the mind maintains awareness, yet does not mingle with the senses, nor the senses with s
Through training of the senses (tapas), there comes a distruction of mental impurities, and an en
When the indriyas cease to be engaged with the corresponding objects and assimilate or turn ba
Craving leads to the extroversion of the inner process -When established in pure awareness, (the

2.5 Ignorance (versus Wisdom)

Ignorance is taking the non-eternal for the eternal, the impure for the pure, evil for good and non
All is misery to the wise because of the pains of change, anxiety, and purificatory acts
When the veil of impurities are removed infinite knowledge is attained; and the knowable finite a
Right discernment is the knowledge of the self
Forgetfulness and the negation of awareness is the state of māyā.
The predominant sign of a yogī is joy filled amazement

2.6 Arrogance (versus Humility & Surrender)

The coloring (klesha) of I-ness or egoism (asmita), which arises from the ignorance, occurs due to
The uniting of the seer (the subject, or experiencer) with the seen (the object, or that which is ex
Mind is not self luminous, being an object
Constructed or created mind springs from a sense of individuality

2.7 Insecurity ( (versus Fearlessness)

Anxiety (abhinivesha) arises spontaneously and can even dominate your entire existence.
As the mutation of gunas (satva, rajas, tamas) cease to function, time stops.
This deconstruction of flow of time is comprehensible only in the final stages of emancipation

2.8 Hypocrisy (versus Truthfulness)

When the modifications of mind have become weakened, the mind becomes like a transparent c
When the consciousness dwells in wisdom, a truth bearing state of direct spiritual perception daw
This truth bearing wisdom is distinct from and different from knowledge gains from books, testim
Blissful sight is the goal of samadhi

2.9 Cruelty (versus Compassion)

Gladness towards happiness and compassion towards misery, makes mind pure
Once a condition of durable non-violence (ahimsa) has been established, all enmity will be aband
When the object of meditation engulfs the meditator, appearing as the subject, self awareness is

ASHTANG YOGA IN THE BHAGAVAD GITA

3.1 Yama (don’t's)
 Hypocrisy, pride, insolence, cruelty, ignorance
The godless do not know how to act or how to renounce. They have neither purity nor truth. The
Giving themselves up to insatiable passions, hypocritical, self-sufficient and arrogant, cherishing f
Poring anxiously over evil resolutions, which only end in death; seeking only the gratification of d
Caught in the
This I have toils today;
gained of a hundred vainI hopes,
tomorrow the slaves
will gratify anotherof desire;
passionthis
andwealth
wrath,isthey
mineaccumulate ho
now, the rest shall be mine ere long
I have slain one enemy, I will slay the others also; I am worthy to enjoy, I am the Almighty, I am p
IPerplexed
am rich, I by
amdiscordant
well-bred;thoughts,
who is there to compare
entangled in thewith me?ofI desire,
snares will sacrifice, I willby
infatuated give, I will pay –
passion, Self-conceited, stubborn, rich, proud and insolent, they make a display of their patronag
Puffed up by power and inordinate conceit, swayed by lust and wrath, these wicked people
The gates of hell are three: lust, wrath and avarice

3.2 Niyama (do's)

Meditation is not for him who eats too much, not for him who eats not at all; not for him who is o
But for him who regulates his food and recreation, who is balanced in action, in sleep and in wak
Qualities of a leader are as follows:
Fearlessness, clean living, unceasing concentration on wisdom, readiness to give, self-control, a s
harmlessness, truth, absence of wrath, renunciation, contentment, straightforwardness, compas
valour, forgiveness, fortitude, purity, freedom from hate and vanity;

3.3 Asana
Excluding external objects, his gaze fixed between the eyebrows, the inward and outward , breat
Having chosen a holy place, let him sit in a firm posture on a seat, neither too high or too low
Let him hold body, head and neck erect, motionless and steady; turning neither to the right nor t

3.4 Pranayama
There are some who practise control of the Vital Energy (control breath to control mind)

3.5 Pratyahara
He who can withdraw his senses from the attraction of their objects, as the tortoise draws his lim
The objects of sense turn from him who is abstemious. Even the relish for them is lost in him who
The mind of him, who is trying to conquer it, is forcibly carried away in spite of his efforts, by his
Restraining them all, let him meditate steadfastly on Me; for who thus conquers his senses achie
All honour to him whose mind controls his senses, for he is thereby beginning to practise Karma-
The love and hate which are aroused by the objects of sense arise from Nature; do not yield to th
First control thy senses and then slay desire, for it is full of sin, and is the destroyer of knowledge
The joys that spring from external associations bring pain; they have their beginning and their en
Renouncing every desire which imagination can conceive, controlling the senses at every point by

3.6 Dharna
When the mind is restrained to one object of awareness, casting all others aside and not allowing

3.7 Dhyana
When one perceives a particular object, vacuity is established regarding all other objects. (Contem
3.8 Samadhi
The saint is awake when the world sleeps, and he ignores that for which the world lives.
He who desires nothing but wisdom and spiritual insight, who has conquered his senses and who
Sages look equally upon all, whether he be a minister of learning and humility, or an infidel, or w
He looks impartially on all – lover, friend or foe; indifferent or hostile; alien or relative; virtuous o
He who experiences the unity of life sees his own Self in all beings, and all beings in his own Self,
Who accepts pain and pleasure as it comes, is centred in his Self, to whom a piece of clay or ston
 Satvik (Buddhi) - Uplifting
Logical
Imagination & Real Knowledge
Thinkers
Why
Disconnect on seeing threat

Generous & Democratic (Win-Win)

Mindset of Abundance

Broad & Long term

Consequence for others

Task Focused
Disciplined (delay of gratification long term good)

ndweller is the bottom

arsara) leads to enlightenment (equanimity towards all gunas)

what material combination

es mind pure
retention of energy (control breath to control mind)

he past and present.

particle to the greatest infinity.

g or loosening of effort, and allowing attention to merge with endlessness, or the infinite
y is just like an object to him

e and pulls one towards such experience.

sery and pushes one from such experience

mutable is the cause of suffering.

of the latter the former too ceases to exist.

consciousness of mastery
from falsehoods, from stealing, from sexual engagements, and from acceptance of gifts
one's own body as well as a cessation of desire for physical contact with others
with the senses, nor the senses with sense impressions, then self-awareness blossoms
uction of mental impurities, and an ensuing mastery or perfection over indriyas
nding objects and assimilate or turn back into the mind-field from which they arose, this is called pratyahara
en established in pure awareness, (the craving) is destroyed

pure for the pure, evil for good and non-self as self.
xiety, and purificatory acts
e is attained; and the knowable finite appears trivial

ises from the ignorance, occurs due to the mistake of taking the intellect to itself be pure consciousness.
he seen (the object, or that which is experienced) is the cause or connection to be avoided.

ominate your entire existence.

ction, time stops.
in the final stages of emancipation

the mind becomes like a transparent crystal

state of direct spiritual perception dawns
m knowledge gains from books, testimony and inference

ery, makes mind pure

n established, all enmity will be abandoned in your environs
earing as the subject, self awareness is lost; this is samadhi
 hey have neither purity nor truth. They do not understand the right principles of conduct.
elf-sufficient and arrogant, cherishing false conception founded on delusion, they work only to carry out their own unholy p
eath; seeking only the gratification of desire as the highest goal; seeing nothing beyond
assionthis
esire; andwealth
wrath,isthey
mineaccumulate hoards of unjust wealth, only to pander to their sensual desire

thy to enjoy, I am the Almighty, I am perfect, powerful and happy;

?ofI desire,
will sacrifice, I willby
infatuated give, I will pay – and I will enjoy. Thus blinded by Ignorance
, they make a display of their patronage, disregarding the rules of decency.
and wrath, these wicked people

who eats not at all; not for him who is overmuch addicted to sleep, not for him who is always awake.
balanced in action, in sleep and in waking, it shall dispel all unhappiness.

dom, readiness to give, self-control, a spirit of sacrifice, regular study of the scriptures, austerities, candour
entment, straightforwardness, compassion towards all, uncovetousness, courtesy, modesty, constancy

brows, the inward and outward , breathings passing equally through his nostrils.
a seat, neither too high or too low
eady; turning neither to the right nor to the left.

ontrol breath to control mind)

ir objects, as the tortoise draws his limbs within its shell – take it that such a one has attained Perfection
en the relish for them is lost in him who has seen the Truth.
ried away in spite of his efforts, by his tumultuous senses.
or who thus conquers his senses achieves perfection
s thereby beginning to practise Karma-Yoga, the Path of Right Action, keeping himself always unattached
se arise from Nature; do not yield to them. They only obstruct the path.
sin, and is the destroyer of knowledge and of wisdom.
they have their beginning and their endings. The wise man does not rejoice in them.
controlling the senses at every point by the power of mind;

asting all others aside and not allowing movement to take place from one to another, then inside that perception the aware

hed regarding all other objects. (Contemplating on that (vacuity) verily, even though the particular object is still known or pe
 hat for which the world lives.
who has conquered his senses and who looks with the same eye upon a lump of earth, a stone or fine gold, is a real saint
arning and humility, or an infidel, or whether it be a cow, an elephant or a dog
or hostile; alien or relative; virtuous or sinful.
l beings, and all beings in his own Self, and looks on everything with an impartial eye;
is Self, to whom a piece of clay or stone or gold are the same, who neither likes nor dislikes, who is steadfast, indifferent ali
 Rajsik (Manas) - Activating Tamsik (Indriya) - Degrading
Emotional Inertia
Chauffeur Knowledge Cynical & Negative
Execution (Getting it done)& Organizing Following Orders
How What
Attacks on seeing threat Follow others on seeing threat

Feudal & Selfish (Win-Lose or Race) Distructive (Lose-Lose), Hostile & Head On
Mindset of Opportunity Mindset of Scarcity

Short term & Narrow Tunnelled (based on habit)

Consequence for self Consequence of neither

Outcome Focused Unfocused

Action (quick results long term discontent) Slothful (instant gratification)

e with endlessness, or the infinite

nts, and from acceptance of gifts
cal contact with others
then self-awareness blossoms
perfection over indriyas
field from which they arose, this is called pratyahara

king the intellect to itself be pure consciousness.

cause or connection to be avoided.
 nd the right principles of conduct.
ounded on delusion, they work only to carry out their own unholy purposes.
st goal; seeing nothing beyond
alth, only to pander to their sensual desire

hus blinded by Ignorance

e rules of decency.

d to sleep, not for him who is always awake.

all unhappiness.

egular study of the scriptures, austerities, candour

uncovetousness, courtesy, modesty, constancy

ally through his nostrils.

– take it that such a one has attained Perfection

Right Action, keeping himself always unattached

struct the path.

an does not rejoice in them.

ke place from one to another, then inside that perception the awareness blossoms

vacuity) verily, even though the particular object is still known or perceived, the mind rests in tranquility
 me eye upon a lump of earth, a stone or fine gold, is a real saint
w, an elephant or a dog

rything with an impartial eye;

same, who neither likes nor dislikes, who is steadfast, indifferent alike to praise or censure
1

5
 Quality of Dividends
If an investor makes a small concession in dividend yield below the standard, he is entitled to demand a more than c
standard. So if a stock is paying 5% div yield and 7% earnings yield and another company paying 4.4% yield, then the
8% to compensate.

In some cases stockholder derive positive benefits from an ultraconservative dividend policy i.e. through much large
market’s judgment proves to be wrong in penalizing the shares because of their small dividend.

Far more frequently, however, the stockholders derive much greater benefits from dividend payments than from ad
reinvested profits fail to add proportionately to the earning power or (b) they are not true profits at all but reserves

In this majority of the cases the market’s disposition to emphasize the dividend and to ignore the additio
$10 and paying $7 in dividends should increase the value of stock over a period of years. This may be true
be substantially less than $3 per annum compounded.

The confusion of thought arises from the fact that the stockholders votes in accordance with the first premise and in

Between the extremes of excellent and poor capital allocators is a world of mediocrity, in which managements often
giving little consideration to the alternatives.

Quality of Earnings

I (Joel Greenblatt) think the hard part is limiting yourself to those companies that you can figure out the normalized
figure out--or are easy to figure out--the normalized earnings.
Intrinsic value is defined as ―that value which is justified by the facts e.g., assets, earnings, dividends, definite prosp
determining value is now held to be the indicated average future earning power

The term "earning power" should be used to mean the earnings that may reasonably be expected over a period of ti
unpredictable, we are usually compelled to take either the current or past earnings as a guide, and to use these figu
earnings.

It is not sufficient to know what the past earnings have averaged, or even that they disclose a definite line of growth
believing that this average or this trend is a dependable guide to the future.

For what the investor chiefly wants to learn from an annual report is the indicated earning power under the given se
expected to earn year after year if the business conditions prevailing during the period were to continue unchanged
The broad study of income accounts may be classified under three headings:

A. The accounting aspect: What are the true earnings for the period studied?
B. The business aspect: What indications does the earnings carry as to the future earning power of the co
finance: What elements in the earnings exhibit must be taken into account, and what standards followed
the shares?
 Graham recommends that when an enterprise pursues questionable accounting policies, all its securities be sh
some of them may appear. You cannot make a quantitative deduction to allow for an unscrupulous managem
them.

Graham gives an example of using the balance sheet to detect a misleading income statement to illustrate the
to an examination of the corresponding balance sheets. In addition, he suggests a further check upon the relia
amount of federal income tax accrued.

Even though the two companies participate in the same business, a line-by-line comparison of their cost ratios
company is more efficient. Analysts must take care not to mistake a difference that is actually a function of bu
managerial skills.

Analysts need to distinguish between internal growth and external growth. Internal growth consists of sales in
while external growth represents incremental sales brought in through acquisitions. (Abel, Baker, Charlie)

A. Accounting Aspect: True Earnings for the Period Studied

To get the true earnings from accounting earnings, the audited statements require critical interpretation and adjust
elements:
1. Non-recurrent profits and losses
2. Operations of subsidaries and affliiates
3. Reserves

1. Non-recurrent profits and losses

What the investor chiefly wants to learn from an annual report is the indicate
the company might be expected to earn year after year if the business conditi
unchanged.
1) Profit or loss on sale of fixed assets: These clearly should be charged directl
A glaring example of this practice is presented by the report of the Manh
earnings of $882,000, or $10.25 per share, which was regarded as a very
additional shares on the New York Stock Exchange revealed that out of t
had been realized through the sale of the company’s battery business. H
$295,300, or about $3.40 per share.

During 1931 the United States Steel Corporation reported “special incom
due to “profit on sale of fixed property”—understood to be certain publ
in the year’s earnings and resulted in a final “net income” of $13,000,00
nature, the analyst would be compelled to eliminate it from his consider
accordingly register a loss of $6,300,000 before preferred dividends.

2) Profit or loss on sale of marketable securities: These are also of special char
results and applied directly to shareholders equity. Reductions in the market v
in the same way as losses from the sale of such securities.
 The report of National Transit Company, a former Standard Oil subsidiar
to the inclusion in the income account of profits from this source.The inc
impressive. But a study of the detailed figures of the parent company alo
Commission, would have revealed that $560,000 of the 1928 income wa
happens to be almost exactly equal to the increase in consolidated net e

During 1931 F.W. Woolworth Company included in its income a profit of

British subsidiary. The effect of this inclusion was to make the per-share
fact they had experienced a recession

Reduction in the market value of securities should be considered as a no

of such securities. The same would be true of shrinkage in the value of fo
write-downs, when made, against surplus. The General Motors report fo
$20,575,000 as deductions from income, but was careful to designate th
(1) the over-all change in principal value is the only available measure of
cannot be regarded as an index of “normal earning power” in any sense
industrial business.

The fact that the operations of financial institutions generally—suc

—must necessarily reflect changes in security values makes their sh
dealings. Since in these enterprises an increase in security values m
inevitable tendency to regard the gains made in good times as part
accordingly. This results of course in an absurd overvaluation, to be
depreciation.

3) Discount or premium on retirement of corporate obligations: A profit can b

their own senior securities at less than par value. The inclusion of such gains in
are non-recurring and second, this is at best a questionable sort of profit, sinc
securities holders

income account shows that the chief “earnings” of Utah Securities we

a discount. Had it not been for this extraordinary item the company w

The International Securities Corporation of America, to use an outstan

November 30, 1932, no less than $12,684,000 of its 5% bonds, repres
was about 55, and the operation showed a profit of about $6,000,000
investment portfolio.

In the industrial field we note the report of Armour and Company for
after including in income a profit of $5,520,000 on bonds bought in at
A contrary result appears when senior securities are retired at a cost excee
involves a large amount, it is always charged against surplus and not agains
As prominent illustrations of this practice, we cite the charge of $40,6
Corporation in 1929, in connection with the retirement at 110 of $307
charge of $9,600,000 made against surplus in 1927 by Goodyear Tire
premium of various bond and preferred-stock issues and their replace
dividend rates. From the analyst’s standpoint, either profit or expense
own securities should be regarded as nonrecurring and excluded from
performance.
4) Proceeds of life insurance policies: Should be applied directly to shareholde
Gimbel Brothers included the sum of $167,660, proceeds of life insura
“nontrading item.” On the other hand, United Merchants and Manufa
1938 fiscal year, more soundly credited it to surplus—although it had

5) Tax refunds and interest thereon: Should be applied directly to shareholder

Although tax refunds are regularly shown as credits to surplus only, th
appears as part of the income account, e.g., $2,000,000 reported by E
unstated but apparently much larger sum
included in the earnings of United States Steel for 1930.

6) Gain or loss as result of litigation: Should be applied directly to shareholder

Bendix Aviation Corporation reported as income for the year 1929 the
suit, and again in 1931 it included in current earnings an amount $242
litigation. The 1932 earnings of Gulf Oil Corporation included the sum
litigation. By means of this item, designated as nonrecurrent, it was ab
$2,743,000.

7) Extraordinary write-downs of inventory: Inventory losses are directly relate

inventories and receivables must be considered part of the operating results.
into account at all (as during the great depression), the losses on inventories m

In these three years Goodyear charged against earnings a total of $11,50

Of this amount one-half was used to absorb actual losses sustained and
eventually used up in 1930). United States Rubber during this period cha
write-downs, all of which was absorbed by actual losses taken. But the fo
stockholders, excluded these deductions from income and made them a
moreover, the inventory loss of $8,910,000 was apparently offset by a sp
earnings of the crude-rubber producing subsidiary)

Wilson and Company set up a reserve of $750,000 prior to the beginning

Valuation.” This was taken partly from surplus and partly from income. I
thus increasing the year’s reported profit by $750,000. The S.E.C., howev
to credit this amount to surplus and not to income.

On the other hand, Swift and Company reduced its reported earnings in
set up as a reserve for future inventory decline. In 1938 the expected de
spare the income account, the company charged the full loss against the
the reserve directly to surplus. In this exceptional case the net income fo
amounts were actually taken out of income and turned over to surplus.

8) Extraordinary write-downs of receivables: Graham cautions to watch out fo

with the intention of benefitting future income accounts. This is essentially co
then reporting these same sums as income.

9) Cost of maintaining non-operating properties: The analyst should consider

category from ordinary charges against income. These expenses should be of
 Youngstown Sheet and Tube Company reported a charge of $2,759,000
Plants, Mines, and Other Properties that were Idle.” Stewart Warner Cor
against surplus in 1932, instead of income, the sum of $309,000 for “Dep
production.” The 1938 report of Botany Worsted Mills contained a charg
“cost of idleness.”

10) Deferred Charges: . Some companies write off such expense applicable to
improper as it understates the operating expenses for a succeeding period of

The Kraft Cheese Company for example, during some years prior to 1927
deferred charge to be absorbed in the operations of subsequent years. I
1926 it spent about $1,000,000 for advertising and charged only one-hal
year the balance of this expenditure was deducted from surplus, and fur
off against surplus to cancel the balance
carried forward from prior years as a deferred charge. By this means the
of $1,071,000 as earned for 1926.

The 1932 report of International Telephone and Telegraph Company sho

$35,817,000, which included the following: “Write-off of certain deferre
originally set up to be amortized over a period of years in accordance wi

In 1933 Hecker Products (then called Gold Dust Corporation) appropriate

the “net cost of introduction and exploitation of new products.” About t
1933–1936, and the balance then transferred to “General and Contingen

11) Amortization of Bond Discount: It was formerly considered conservative to

surplus, in order not to show so intangible an item among the assets on the b
eliminate future annual deductions from earnings.
Associated Gas and Electric Company charged against surplus in 1932 th
written off.

2. Operations of subsidaries and affliiates

The charging of current advertising expense to the good-will account is inadm

without any disclosure to the stockholders is still more discreditable. It is diffic
could have been expended for this purpose by Park and Tilford in the three m
The entry appears therefore to have included a recrediting to current income
extent the results for the fourth quarter of 1929 may have been flagrantly dis
accompanied the annual statements of this enterprise.
Graham also cautions on including leasehold appreciation in the current earni
amortized over the life of the lease.

1. Leaseholds are essentially as much a liability as they are an asset. They

Ironically enough, these very leaseholds of United Cigar Stores eventuall
2. Assuming leaseholds may acquire a capital value to the occupant, such
accounting principles to mark up above actual cost the value of such inta
3. If the value of any capital asset is to be marked up, such enhancement
imagination can it be considered as income.
 4. The $20,000,000 appreciation of the United Cigar Stores leases took p
subsequent years. There was thus no connection between the $2,437,00
operations or developments of that year.
5. If the leaseholds had really increased in value, the effect should be vis
locations. Any other recognition given this enhancement would mean co
for extensions of the business financed by additional capitalization, the p
advancing trend.
6. Whatever value is given to leaseholds must be amortized over the life
paying a high price for the shares because of earnings produced by these
an allowance to write off this capital value by the time it disappears thro
Company continued to amortize its leaseholds on the basis of original co
surprising truth of the matter, therefore, is that the effect of the appreci
have been to reduce the subsequent operating profits by an increased a

The accounting practice of Tobacco Products introduced still another way of p

valuation upon stock dividends received.

It is to be noted that Tobacco Products must have valued the stock divid
times their face value, i.e., at three times the value at which United Ciga
this valuation by Tobacco Products was the market price of United Cigar
to the small amount of stock not owned by Tobacco Products.
When a holding company takes into its income account stock dividends
the subsidiary that pays them, we have a particularly dangerous form of

The analyst must endeavor to adjust the reported earnings so as to reflect as

of controlled or affiliated companies.

The 1938 report of American Tobacco Company showed by way of footnote

subsidiaries exceeded their earnings by $427,000. Hercules Powder reporte
form, whereas prior to 1937 it had included its share of the undistributed e
Income.” Railroad companies handle this matter differently. The Atchison,
account data of affiliates in an Appendix to its own report, which continues
companies.

The analyst should adjust reported earnings for the results of non-consolidate
income account and if the amounts involved are significant. The criterion here
importance of the holdings. (Buffetts look through earnings)

Look-through" results, calculated as follows: Take $250 million, which is

retained by our investees; subtract $30 million, for the incremental taxe
to us in divi- dends; and add the remainder, $220 million, to our reporte
"look-through earnings" were about $590 million.

the interest of Du Pont in General Motors, representing about 23% of th

effect on the owning company to warrant adjustment of its earnings to r
done by Du Pont each year in the form of an adjustment of surplus to re
General Motors holdings. The analyst would prefer, however, to make th
calculated earnings of Du Pont.
 When earnings of nonconsolidated subsidiaries are allowed to accumulate in the
accounts, they may be used later to bolster up the results of a poor year by mea
company.

Such dividends, amounting to $11,000,000, were taken by the Erie Railroad

and Hillside Coal and Iron Company. The Northern Pacific Railway Company
1931 by means of large sums taken as special dividends from the Chicago, B
Express Company, and the Northwestern Improvement Company, the last b
1931 earnings of the New York, Chicago, and St. Louis Railroad Company in
holdings of Wheeling and Lake Erie Railway Company Prior Preferred Stock
Wheeling road.

the parent company went to the extraordinary lengths of donating the sum
immediately took the same money back as a dividend from its subsidiary. T
the same money as dividends it reported as earnings. In this devious fashio
stock, when in fact the applicable earnings were only about $2 per share.

In 1929 Nickel Plate sold, through a subsidiary, its holdings of Pere Marque
same control. A profit of $10,665,000 was realized on this sale, which gain
needed to increase its income; whereupon it took the $10,665,000 profit o
and then took $3,000,000 thereof in the form of a “dividend” from this sub
dividend of $2,100,000 was included in the income account for 1931.

Subsidiary losses: Hence, if good management is assumed, must we not also a

and therefore to be regarded as non-recurring items rather than as deduction
If the subsidiary could be wound up without an adverse effect upon the
losses as temporary. But if there are important business relations betwe
termination of its losses is not so simple a matter.
1. In the first instance, subsidiary losses are to be deducted in every anal
2. If the amount involved is significant, the analyst should investigate wh
termination.
3. If the result of this examination is favorable, the analyst may consider
nonrecurring item.

3. Reserves
The analyst must give critical attention to the matter of reserves for depreciati
other contingencies. These reserves are subject in good part to arbitrary dete

a) Depreciation
First, accounting rules themselves may permit a value o
Second, many companies fail to follow accepted accoun
the income account; Third, there are occasions when an
standpoint will fail to meet the situation properly from a
Two typical misuses of depreciation base accounting by
the interests of conservatism but with the precisely opp
marking up fixed assets yet failing to correspondingly inc
account.
 In 1926 American Ice Company wrote up its fixed assets
correspondingly to restore the valuations to a cost basis
charges thereafter against income, and the 1935 reducti

In 1933 American Locomotive Company reduced the sta

most of the capital surplus thus created to write down fi
in General Steel Castings Corporation by about $6,200,0
depreciation charges to about 40% of their former level

There is some criticism in accounting circles of the propr

from original cost. In our opinion they are not objection
1. The new values are set up in the bona fide conviction
old values.
2. Proper depreciation against these new values is charg
In many cases, however, we find that companies revalui
assets fail to observe one or the other of these condition

Hall Printing Company wrote up its property accou

“appraisal increment” to capital surplus. Depreciati
capital surplus, instead of to income; e.g., typically
$406,000 for such depreciation against surplus and
April 1938 the balance of the appraisal increment w
and capital surplus; and the special depreciation ch

Borg Warner has been charging about $102,000 pe

to “Appreciation Surplus,” instead of to income, to
Depreciation Rate: Most companies use the standard de
company’s depreciation policy differs from the standard
allowance. depreciation to property account and ratio o
Analysts should be wary of companies that report lower
(PP&E) than their industry peers. The implication is that
assets more slowly than the norm.
Comparative depreciation charges at times become quit
of consolidation.

In 1924 a merger plan was announced embracing the

“Nickel Plate,” and Erie railroads. Some Chesapeake a
Interstate Commerce Commission that the terms of t
other matters they
pointed out that the earnings of Chesapeake and Ohi
higher than stated, due to the unusually heavy charge
equipment. A similar objection was made in connecti
Youngstown Sheet and Tube in 1929, which plan was

AMORTIZATION CHARGES IN OIL AND MINING COMPANIES:

1. Depreciation on Tangible Assets. This should always b
to a figure substantially less than cost only if the facts cl
 2. Intangible Drilling Costs. We believe that capitalizing t
—although less “conservative”— is the preferable basis
reflection of current earnings. In comparing companies t
make the best allowance he can for the understatement
first year.
3. Property Retirement and Abandoned Leases. We thin
already accrued) should be charged against the year’s ea
companies in other fields. The reason is that property re
in the business

4.Depletion of Oil Reserves. The proper theoretical princ

on the basis at which the oil reserves are valued in the m
OTHER TYPE OF AMORTIZATION OF CAPITAL ASSETS:
If a company has paid money for a leasehold, the cost is
off during the life of the lease. These charges are in reali
obviously be included in current operating expense
When structures are built on leased property or alterati
“leasehold improvements.” Hence their cost must be wr
they belong to the landlord when the lease expires. The
“amortization of leasehold improvements.” It partakes t
Chain-store enterprises frequently invest considerable s
the annual write-offs thereof may be of appreciable imp

Since these items belong to the amortization group, the

treatment as do the others. By making the annual charg
the entire capital investment to $1 and thus eliminating
these items of operating cost from its reported per-shar
large.
AMORTIZATION OF PATENTS
In theory, a patent should be dealt with in exactly the sa
should be written off against earnings during its remaini
against earnings by the company— which are based on
relevance to the real situation.

It follows that the $1 valuation of patents is the soundes

can be added back to earnings if the amount is substanti
hence, if such amortization is charged to surplus instead
figure.
When a company’s business consists primarily in collecti
possible to make a more definite provision for amortizin
provision must be related to the price paid by the
investor for his interest in the patent, rather than to the
amortization charge is based.

AMORTIZATION OF GOODWILL
A few companies have followed the rather extraordinary
earnings in a number of annual installments. Obviously,
duration of life apart from that of the business as a who
adjust the earnings by canceling the charge.
AMORTIZATION CHARGES FROM INVESTMENT STANDPOINT
Depreciation or depletion charge that is technically prop
situation properly as it concerns the buyer of the compa
Eureka Pipe Line Company for the three years 1924
$73,000 per annum, so that there was available in
to working capital or used for dividends (which we
clear that this business had been a producer of cas
substantial going-concern value, although the high
none. So the income statement suggests that the c
statement suggest otherwise
Let us now consider examples involving the opposite typ
corporations that give rise to inadequate allowances for
vogue for drastic write-offs of fixed assets for the admitt
thereby increasing the reported earnings.
Early in 1933 the United States Industrial Alcohol C
Company announced plans under which the prope
means of a corresponding reduction in stated capit

Commercial Solvents Company wrote down its pla

Kaufmann Department Stores both wrote down th
1929, respectively. Park and Tilford Company wrot
In all these cases subsequent depreciation charges

Rule 1: The company’s amortization charges are to be ac

a. They are based on regular accounting rules applied to
b. The net plant account has not decreased over a perio
Rule 2: The company’s charges may be reduced in the an
expenditures on the property. In such a case the averag
provisional depreciation charge and the balance of depr
which tends to reduce the valuation of the average cash
based upon the price paid for the enterprise by the inve
reproduction cost of the fixed assets.

Rule 3: The company’s charges must be increased in the

average cash expenditures on the property and less than
applied to the fair value of the fixed assets used in the b
Graham’s conception of earning power is equivalent to f
tax) - Capex ; FCFE = CFO - Capex + Net Borrowing ).
Buffetts owner earnings is similar - "owner earnings." Th
depreciation, depletion, amortization, and certain other
capitalized expendi- tures for plant and equipment, etc.
competitive position and its unit volume. (If the busines
competitive position and unit volume, the increment als

CONTINGENCY AND OTHER RESERVES

 Conservatively managed companies in former days were wont to
of good years to absorb any special losses that might later arise,
equalize the earnings in prosperity and depression. In this respe
subsidiary companies

The annual report of the Coca-Cola Company for 1928 stated tha
strengthened during the last five years by setting aside a reserve
Reports for the preceding five years showed that the reserve ha
varying amounts and for a miscellany of purposes. In the years 1
1934, with the result that the “Reserve for contingencies and mi
income amounted to $13,011,479 at the end of 1939.

In 1939 Continental Steel Company deducted $300,000 as a rese

second half-year, reducing the earnings per share from $4.62 to
4. Other Shenanigans
Does the company recognize revenue upon shipment (referred t
point) or upon delivery (referred to as FOB destination) of goods
recognized upon dispatch of goods, while under the latter, reven
goods reach the customer.
At other times, for shipments toward the end of the reporting p
destination. Management may engage in this practice if there w
period, and it does not want investors/analysts to get too optim

If the ratio of accounts receivable to revenues is abnormally high

chance that channel stuffing has occurred.

A company can reduce its allowance for sales returns as a propo

reduce expenses and increase profits.Analysts should examine w
tended to be different from historical provisioning in order to as

If a company participates in “bill‐and‐hold” transactions (where

remain with the seller until a later date), it is possible that it is re
inventory as “sold but held” through minimal effort and fake doc
and‐hold” sales)

If the company uses rebates as part of its marketing approach, c

manipulate reported revenues and profitability (similar to allow

If the company separates its revenue arrangements into multipl

goods or services, investors should look out for any changes in th
revenue across the deliverables.
Does the company adequately disclose how revenue is allocated
each one?
■ If a certain portion of revenue is recognized over time (as in t
deferred revenues?
■ Are there unusual trends in revenues and receivables, especia
If the company has recorded significant asset write‐downs in the
relating to asset lives need to be examined.
Analysts should also examine how the company’s capitalization
whether its amortization policies are reasonable.
Analysts should determine how a company’s inventory methods
reserves for obsolescence in its inventory valuation, unusual
fluctuations in this reserve might suggest that the company is m
If a company uses LIFO in an inflationary environment, it can tem
liquidation (where sales exceed purchases over the period, enab
old, lower prices, thereby deflating COGS).
Analysts must evaluate whether the company’s estimate of the
operating environment and future prospects.
Analysts should examine whether warranty reserves have been
in actual costs relative to amounts allocated to reserves should b
products sold.
If the company engages in extensive dealings with nonpublic com
management control, the nonpublic companies could be used to
through supply arrangements that are unfavorable to the nonpu
improve the public company’s reported performance.

Growth in revenue higher than that of industry or peers

Increases in operating margin
Large proportion of revenue in final quarter of year for a non‐se
Typical current assets, such as accounts receivable and inventor
High goodwill value relative to total assets. Because goodwill is n
net assets acquired to understate depreciation/amortization cha
income.

Use of special purpose vehicles

Significant off‐balance‐sheet liabilities
Increase in accounts payable and decrease in accounts receivabl
Capitalized expenditures in investing activities
Sales and leaseback transactions
Increase in bank overdrafts
Companies that are finding it difficult to generate cash may acqu
to increase cash flow from operations. If the acquisition is paid f
will be reported under investing cash flow (note that there may
acquisition is paid for with equity), while reported consolidated
will include the cash flow of the acquired company. Note that th
operations may or may not be sustainable.

If a company reports non‐financial data on a routine basis, try re

data to determine whether trends in the revenue make sense. E
○ Airlines reporting extensive information about miles flown and
an analyst to relate increases in revenues to an increase in miles
○ Retailers reporting square footage used and number of stores
○ Companies across all industries reporting employee head coun
 Does the company transact business with entities owned by sen
shareholders? This is a particularly sensitive area if the manager
entities are private and there are revenues recognized from the
owned company; it could be a dumping ground for obsolete or d
inflating revenues.

If unusual buildups of non‐current assets have occurred and the

could mean that improper cost capitalization is taking place.
Compare the relationship of capital expenditures with gross pro
and equipment over time. Is the proportion of capital expenditu
total property, plant, and equipment increasing significantly ove
it may indicate that the company is capitalizing costs more aggre
prevent their recognition as current expenses.

If a company reports substantial amounts of goodwill, but its ma

shareholders’ equity, it may suggest that goodwill is impaired bu
Valuation of pension liabilities requires several estimates
including the discount rate and other actuarial assumptions (tha
an earlier Reading). Any changes in these assumptions should be
Note that these warning signs are signals, not declarations of acc
They should be evaluated cohesively, not on an isolated basis. If
warning signs, the particular investment should be viewed with
discarded in favor of other alternatives.

B. Business Aspect: Indications regarding future earning power

The past exhibit remains a sufficiently dependable guide, in a sufficient proportion of cases, to warrant its continued
selection of securities
In order for a company’s business to be regarded as reasonably stable, it does not suffice that the past record shoul
considered apart from any figures, must be such as to indicate an inherent permanence of earning power.

A distinction must be drawn, however, between an average that is the mere arithmetical resultant of an assortment
or ―modal, in the sense that the annual results show a definite tendency to approximate the average.
The market level of common stocks is governed more by their current earnings than by their long term average. Thi
common stock prices, which largely (though by no means invariably) parallel the changes in their earnings between
An investor may on occasion attach predominant weight to the recent figures rather than to the average, but only w
continuance of these current results.

Instead of taking the maintenance of a favorable trend for granted – as the stock market is wont to do – the analyst
determine the causes of the superior showing and to weigh the specific elements of strength in the company’s positi
continued growth.

Attitude of Analyst Where the Trend is Upward - price levels for ―good stocks under normal market conditions are
student. This does not mean that the analyst is convinced that the market valuation is wrong but rather that he is no
substantial part of the price a ―speculative componen in the sense that it is paid not for demonstrated performanc
Attitude of Analyst Where the Trend is Downward – When the trend has been definitely downward, the analyst will
not assume that the downcurve must presently turn upward, nor can he accept the past average – which is much hi
earnings. But he will be chary about any hasty conclusions to the effect that the company’s outlook is hopeless, that
the stock is therefore without merit or value. A qualitative study of the company’s situation and prospects is essenti
relatively low, of course, the issue may not be a bargain, despite its declining earnings trend.

C. Aspects of Investment Finance: Reasonable Valuation for the Shares

The intrinsic value of a common stock preceded by convertible securities, or subject to dilution through the exercise
enjoyed by other security holders, cannot reasonably be appraised at a higher figure than would be justified if all su

Security analysis cannot presume to lay down general rules as to the proper value of any given common stock. Practi
In most instances the investor should derive the investment value of common stock from the average earnings of a
that all common stocks with the same average earnings should have the same value.
He suggests that about 20 times average earnings is as high a price as can be paid in an investment purchase of a co
About 12 or 12.5 times average earnings may be suitable for the typical case of a company with neutral prospects. A
not the only requisite for a common stock investment. This is a necessary but not a sufficient condition.
Earnings are reasonably stable, average earnings bear satisfactory ratio to market price and financial setup is sufficie
Another characteristic (though not required) is that they will not sell for a huge premium above the companies actu

D. Sources of Income

Graham suggests that the source of income be studied in relation to specific assets owned by the company, instead
business. This may be quite important when a substantial portion of the income accrues from investment holdings o

Quality of Assets
A stock does not become a sound investment merely because it can be bought at close to its asset value. The invest
earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintaine

If a company could be bought at a price well below liquidation value, then it seemed unambiguously to be a bargain
improvement in firm’s industry environment or better management.
Firms often have some assets – most notably cash – that are superfluous to the operation of their basic businesses.
earnings but they may represent an important part of the intrinsic value of a purchased security. The value of these
estimate (after appropriate subtraction of their interest income so as to not double count).

Liabilities side of the balance sheet, which identifies sources of funding, describes the financial condition of the firm
expires in the near future) indicates a possibility of debilitating financial distress. Under these circumstances, even a
permanent loss in the value of a business.
The evolution of the balance sheet over time provides a check on the quality of earnings. A balance sheet can be che
and liabilities at a particular time.
In present day balance sheets, division between capital & Surplus can be quite meaningless, for most purpose of an
The book value really measures, not what the stockholders could get out of their business (its liquidating value), bu
undistributed earnings.
it is not possible to lay down any rules on the subject of book value in relation to market price, except the strong rec
what he is doing on this score and be satisfied in his own mind that he is acting sensibly.

The book value is of some importance in analysis because there may be some relationship between the amount inve
realizable value. There is always a possibility that large earnings on the invested capital may attract competition and
earning profits, may later be made more productive, or they may be merged, sold as a whole, or liquidated pieceme
stock.
The book value per share of a common stock is found by adding up all the assets (excluding intangibles), subtracting
then dividing by the number of shares. As an alternative, it is sufficient to add together the common stock at par or
voluntary reserves, and to subtract any arbitrary items for intangibles. This will give the total common-stock equity,

Adjustment may be made, if desirable, to correct the stated liability for preferred stock. The proper calculation of th
follow is to value stocks with preference claims at the highest of their par value, call price, or market price. Where t
deducted as well in arriving at the book value for common. In the case of a high-coupon noncallable preferred, a "sy
rate, may be more appropriate than any other measure. As an illustration, consider U.S. Steel 7% noncallable prefer
$360,281,100, representing 3,602,811 shares of $100 par value. A more realistic appraisal would be $140 a share, ar
this basis the liability becomes $504,393,540, an increase of $144,112,440.

IN CALCULATING the book value of a security, the various forms of surplus are all treated simply as surplus. For exam
appropriated surplus, premium on stock sold, and profit and loss or earned surplus. These would all be added toget
In the chapter on reserves, it was mentioned that certain kinds of reserves are really a part of the surplus. These inc
definite and reasonably probable payment or loss of value); general reserve, reserves for dividends, reserves for pre
reserves for working capital, etc. Reserves for insurance may also properly be considered in the same class, but rese
not be included as part of the surplus. These reserves equivalent to surplus (sometimes called "voluntary reserves")
with the surplus in figuring the book value. In finding the net book value all the intangibles should be deducted. Suc
unamortized bond discount, should also be excluded.

But in the absence of a catalyst, I don't feel very excited about holding companies as I used to at one point of time. I
such situations to work ou in the absence of a catalyst. This is pretty much the case with close-ended mutual funds a
bad corporate structures. Holding companies have an unlimited life because they are companies and not funds. This
funds run by managements who really have no interest in unlocking value for their shareholders.

In contrast, when you get a cash-generating operating business, a zero-debt company, lots of cash on the balance sh
from the net cash on the balance sheet, you have an attractive, low risk, high reward situation. By high reward, I do
least twice of the AAA bond yield, which incidentally, is what a Grahamite tries to look for.

The current-asset value of a stock consists of the current assets alone, minus all liabilities and claims ahead of the iss
fixed and miscellaneous assets as well.
The current-asset value is generally a rough index of the liquidating value

It is found by taking the net current assets (or "working capital") alone and deducting therefrom the full claims
less than its net current asset value, this fact is always of interest, although it is by no means conclusive proof t
The phenomenon of many stocks selling persistently below their liquidating value is fundamentally illogical. It
in the judgment of the stock market, (b) in the policies of the company’s management, or (c) in the attitude of
Common stocks in this category practically always have an unsatisfactory trend of earnings.

The objection to buying these issues lies in the probability, or at least the possibility, that the earnings will dec
dissipated and the intrinsic value ultimately become less than the price paid. It may not be denied that this do
hand, there is a much wider range of potential developments which may result in establishing a higher market
 - The creation of an earning power commensurate with the company’s assets as a result of general improvem
operating policies with or without change in management.
 - A sale or merger, because some other concern is able to utilize the resources to better advantage.
 - Complete or partial liquidation.

He will lean towards those for which he sees a fairly imminent prospect of some one of the favorable developm
reveal other attractive statistical features besides their liquid asset position e.g. satisfactory current earnings o
will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing
Investment in such bargain issues need to be carried out with some regard to general market conditions at the
are neither extremely high nor extremely low.
Certain kinds of receivables may be relatively noncurrent — e.g., amounts due from officers and employees, in
to be received by the company within a year, they are usually shown separately from the current assets. On th
of installment accounts receivable in the current assets, even though a good part may be due later than one ye
entire merchandise inventory is included in the current assets, although some of the items may be slow movin

The cash-asset value of a stock consists of the cash assets alone, minus all liabilities and claims ahead of the iss
those directly equivalent to and held in place of cash. They include certificates of deposit, call loans, marketabl
insurance policies

A shortage of cash is ordinarily taken care of by bank borrowings. In the usual case, therefore, a weak financial
loans than through insufficient cash on hand.
During recessionary stages in the economy it is particularly important to watch the cash account from year to y
even during periods of operating losses by liquidating a large part of their other assets, especially inventories a
cash or—what amounts to the same thing— a substantial increase in bank loans.

The more usual purpose of balance sheet analysis is to detect the presence of financial weakness that may det
issue. Careful buyers of securities scrutinize the balance sheet to see if the cash is adequate, if the current asse
is any indebtedness of near maturity that may threaten to develop into a refinancing problem

Previously a working capital ratio of $2 current assets for $1 of current liabilities was regarded as standar
financial strength is the so-called “acid test,” which requires that current assets exclusive of inventories b
Large Bank Debt Frequently a Sign of Weakness: Financial difficulties are almost always heralded by the p
time.his does not mean that bank debt is a bad sign in itself – the use of reasonable amount of bank cred
whenever the statement shows Notes or Bills Payable, the analyst will perform closer scrutiny.

The fact that a company has borrowed from the banks is not in itself a sign of weakness. Seasonal borrow
active sales period, are considered desirable from the viewpoints both of the company and the banks. Bu
may be well covered by current assets, are likely to be an indication that the company is in need of long-t
The Danger of Early Maturing Funded Debt: A large bond issue coming due in a short time constitutes a c
unfavorable. Maturing funded debt is a frequent cause of insolvency.
If the borrowings are larger than the cash and receivables combined, it is clear that the company is relyin
unusually liquid character, such a situation may justify misgivings. In such a case the bank loans should be
have been growing faster than sales and profits. If they have, it is a definite sign of weakness.

A shortage of cash is ordinarily taken care by bank borrowings. In the usual case, therefore a weak financ
bank loans than through insufficient cash on hands.

Other Accounts:

As in the case of inventories, receivables should be studied in relation to the annual sales and in relation
increase in receivables as a percentage of sales may indicate that an unduly liberal credit policy is being e

The accounts receivable require the most careful scrutiny in the case of companies selling goods on a lon
stores, credit chains, and mail-order houses. Farm implements, trucks, and office equipment are also sold
is carried on through finance companies which advance funds against the notes or guarantee of the selle
repurchase agreement from the manufacturer. In these instances neither the receivable nor the debt app
but is referred to in a footnote. In analyzing the balance sheet such discounted receivables should be give
liabilities.

The comparison of inventory turnover among companies within an industry will in many cases reveal an i
leading companies in the group. But this fact in itself is not conclusive unless all the companies being com
inventory. The true turnover is found by dividing the inventory into the cost of sales, but it is customary t
The property account should neither be accepted at face amount nor overlooked entirely. It deserves rea
securities.
Non current investments are usually shown on the balance sheet at cost, though they frequently are redu
are increased to allow for accumulated profits. It is difficult to estimate the true value of these investmen
items are likely to be of importance, a special effort should be made to obtain additional information reg
With high degree of uncertainty, recording the true value of oil reserves is not a realistic objective for acc
hope for in- formed guesses, and there is considerable room for honest people (not to mention rogues w

Some investments stand midway between ordinary marketable securities and the typical nonmarketable
intermediate type is illustrated by du Pont's enormous holdings of General Motors, or the large investme
railroads. Such holdings will appear among the miscellaneous assets rather than the current assets, since
but for some purposes (e.g., calculating the quick assets per share of stock) it is permissible to regard the

Writing down of good will does not mean that it is actually worth less than before, but only that the man
accounting policy. This point illustrates one of the many contradictions in corporate accounting. In most c
company's position has improved. But this means that the good will is, in fact, considerably more valuabl
It is extremely difficult to decide what is the true or fair value of a patent at any given time, especially sin
power is dependent on any patent that it controls. The value at which the patents are carried on the bala
worth.
Little if any wieght should be given to the figures at which intangibles appear in the balance sheet. It is th
balance sheet value that counts.
The "leasehold" item is supposed to represent the cost or money value of long-term leases held at advan
space could be leased. But in a period of declining real estate values, long-term leaseholds are just as like
should be chary of accepting any valuation ascribed to that item.
In general, it may be said that little if any weight should be given to the figures at which intangible assets
a very large value indeed, but it is the income account and not the balance sheet that offers the clue to th
intangibles, rather than their balance-sheet valuations, that really counts.

IT IS useful to divide reserves into three classes:

1. Liability reserves, which represent a more or less definite obligation.
2. Valuation reserves, which are offsets against the stated value of some asset.
3. Surplus or "voluntary" reserves, which merely set aside part of the reinvested earnings.

(1) valuation reserves should be deducted directly—as "allowances"—from the affected asset; (2) reserve
classified as current liabilities or as reserves for specified contingencies; (3) those of an indefinite nature

Over a longer period, a rise in the percentage of assets represented by property, plant, and equipment ca
capital- intensive. By implication, fixed costs are probably rising as a percentage of revenues, making the

Comparison of Balance Sheets Over a Period of Time: This important part of security analysis may be con

1. As a check on the reported earnings per share.

Comparing the total earnings for a company over a 10 year period as reported by the income sta
balance sheet over this period provides a check on the reliability of the earnings reported. This w
the balance sheet without going through the income statement, thus overstating the reported ea
earnings – Total 10 year Dividends paid
The analyst must examine both the income statement and the reinvested earnings over several yea
surplus (reinvested earnings) or reserves which really represent business losses during the period.
2. To determine the effect of losses (or profits) on the financial position of the company

Sometimes while taking losses the company may actually improve its financial position and likew
a deteriorating financial position. Losses that are represented solely by a decline in the inventory
financed by an increase in current liabilities. If the shrinkage in the inventory exceeds the losses,
payables, the company’s financial position has been strengthened even though it has been suffer
deterioration of the financial position due to heavy expenditure on plant and a dangerous expan

3. To trace the relationship between the company’s resources and it’s earning power over a long pe
exhaustive study of a company’s record and inherent characteristics.

Finished goods produced

Gross sales
Operating expenses
Operating ratio = operating expenses / gross sales
Net earnings
Bond interest & Preferred Dividends
 Bond interest & Preferred Dividends / Gross revenues
Common dividends
Capital at beginning
Capital at end
Average Capital
% earned on average capital
Average common equity
% earned on average common equity
Depreciation per year
Average fixed property account
Ratio of depreciation to fixed property
Revenue / PPE
Assets / Profit
Goodwill / Assets
Sales per dollar of working capital
Working capital available per dollar of common stock
Change in working capital over the years
Receivables as percentaege of sales
Charges to surplus not included in income
Capital expenditure / Gross PP&E

Quality of Cash Flows

While less than the flexibility available in the measurement and reporting of earnings, there is flexibility available in
flow without altering the total change in cash.
Cash provided by operating activities may include many nonrecurring items and, accordingly, is not necessarily a sus
outflows of cash that may be reported as part of operating cash flow include: cash inflows resulting from the operati
income taxes on items classified as investing or financing activities, cash flow arising from the purchase and sale of t
cash payments associated with restructuring charges.

Isolate nonrecurring cash inflows and outflows and adjust reported cash provided by operations, including:
 1. Cash flow resulting from the operating income component of discontinued operations
2. Income taxes paid or recovered on transactions classified as investing or financing activities, including:
a. Gain or loss on sale of assets, investments, or businesses
b. Gain or loss on disposal of discontinued operations
c. Extraordinary items, especially early retirement of debt
d. Changes in accounting principle, if any
e. Tax benefits of nonqualified employee stock options
3. Cash flow from the purchase and sale of trading securities
4. Capitalized expenditures that other companies expense as incurred
a. In particular, capitalized software development costs
5. Nonrecurring cash income and expense
a. Cash receipts arising from nonrecurring income
b. Cash payments arising from nonrecurring charges
6. Significant isolated events leading to changes in operations-related assets and liabilities, including:
a. Factoring or securitization of receivables
b. Special inventory reduction sale outside normal channels

Compute adjusted cash flow provided by continuing operations

1. Adjust reported cash flow provided by operating activities for identified nonrecurring cash flow items
Compute adjusted income from continuing operations
1. Adjust reported income from continuing operations for nonrecurring items of income and expense
Compute the adjusted cash flow–to–income ratio
1. Adjusted cash flow provided by operating activities divided by adjusted income from continuing operations.
a. Compute for several years and quarters
b. Examine results for discernible trend

A continuing excess of earnings growth over the rate of growth in operating cash flow may indicate that earnings ha
premature or fictitious revenue recognition, aggressive cost capitalization, extended amortization periods, or intenti
Earnings are at increased risk for decline.

Continuing excess of operating cash flow growth over earnings growth may indicate that the balance sheet is being
operating cash flow.

A truly sustainable relationship between earnings and operating cash flow requires that the two measures grow at c

Excess cash margin (ECM) is an effective tool for measuring the relative growth rates in earnings and operating cash
ECM = ((Operating cash flow – Operating earnings) / Revenue) × 100.
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ASK THE RIGHT QUESTIONS - Every business will have its unique powerpoint

LEADERSHIP
Is the CEO self-promoting?
Does the management have a determination to continue to develop products or processes that will still further incr
currently attractive product lines have largely been exploited?
Does the management talk freely to investors about its affairs when things are going well but “clam up” when troub
Does the company have a management of unquestionable integrity?

A CEO who doesn't perform is frequently carried indefinitely. One reason is that performance standards for his job
be waived or explained away, even when the performance shortfalls are major and repeated. At too many compan
then hastily paints the bullseye around the spot where it lands.

CEO has no immediate superior whose performance is itself getting measured. The sales manager who retains a bu
himself. It is in his immediate self-interest to promptly weed out his hiring mistakes. Otherwise, he himself may be
faces the same imperative. But the CEO's boss is a Board of Directors that seldom measures itself and is infrequent
A good managerial record (measured by economic returns) is far more a function of what business boat you get int
effort help considerably, of course, in any business, good or bad)

When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental eco
How would you evaluate this business if you were to become its CEO?
Does the CEO manage the business to benefit all stakeholders?
Does management think independently and remain unswayed by what others in their industry are doing?
To become more successful, a firm needs a leader with a determined entrepreneurial personality combining the dr
fortunes of the firm.
Attention must be paid to attracting competent managers at lower levels and to training them for larger responsibi
pool. The need to recruit the chief executive from outside is a particularly dangerous sign
The entrepreneurial spirit must permeate the organization.
1. Is management rational?
2. Is management candid with the shareholders?
3. Does management resist the institutional imperative?
In evaluating people, you look for three qualities: integrity, intelligence, and energy. If you don’t have the first, the
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R&D
Does the comapany have products and services with sufficient market potential to make possible a sizable increase
People don’t buy products but uses of product
Growth should not be judged because of one year but by units of several years
Two kind of companies - fortunate and able (Alcoa) & fortunate because they are able (DuPont)
Correctly judging the long range sales curve of a company is of extreme importance
A franchise as a company whose product or service (1) is needed or desired, (2) has no close substitute, and (3
How effective are the company’s research and development efforts in relation to its size?
Companies vary a lot in what they include as R&D expense and what they exclude
Necessary to have leaders who can coordinate the skills of different experts
Close relationship between research, production and sales
Coordination skill of top management - would they abandon research projects
Does the company benefit from low margin government contracts whose know how can be transfered to high
Does the company do worthwile market research
Competitive destruction-You know, you have the finest buggy whip factory and all of a sudden in comes this little h
whip business is dead. You either get into a different business or you're dead - you're destroyed. It happens again a
"Surfing" - when a surfer gets up and catches the wave and just stays there, he can go a long, long time. But if he ge
Since Croesus was the supremely rich king of Lydia (modern day Turkey), the question is what would you do if mon
A firm must have a strong enough customer orientation to recognize changes in customer needs and interests and
manner. This capability should lead to generating a flow of new products that more than offset lines maturing or be
Even nontechnical firms today require a strong and well-directed research capability to (a) produce newer and bett
efficient way
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STRATEGY
Can company increase prices to pass cost increases to customers
Excess capacity can curtail the ability to pass price increase to customers
Are there other aspects of the business somewhat peculiar to the industry involved which will give the investor imp
relation to its competition

Company must have other source of competitive advantage rather than patent protection
Engineering that is constantly improving the product is far more valuable than patent protection
To be a truly conservative investment, company must be a low cost producer

Favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product d
significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume in- cre
growth) with only minor additional investment of capital.
Strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of ta
Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on
The capitalized value of this excess return is economic Goodwill.
Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not
an enduring position as the low cost producer in an industry.
True economic Goodwill tends to rise in nominal value proportionally with inflation
Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation.
Leaving the question of price aside, the best business to own is one that over an extended period can employ large
capital at very high rates of return. The worst business to own is one that must, or will, do the opposite-that is, con
rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need rela
benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

Time is the friend of the wonderful business, the enemy of the mediocre
Invert always invert - think what can go wrong with the business - and avoid it
I can’t understand what I can't recreate - Munger on Coke
Cognition misled by tiny changes involving low contrast will often miss a trend that is destiny
Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as
the business world - and get very good because they specialize - frequently find good economics that they wouldn'
In terms of which businesses succeed and which businesses fail, advantages of scale are ungodly important.

One great advantage of scale taught in all of the business schools of the world is cost reductions along the
in more and more volume enables human beings, who are trying to improve and are motivated by the ince
The very nature of things is that if you get a whole lot of volume through your joint, you get better at proce
lot to do with which businesses succeed and fail
If you were Proctor & Gamble, you could afford to use this new method of advertising. You could afford the
selling so damn many cans and bottles. Some little guy couldn't. And there was no way of buying it in part.
volume, you couldn't use network TV advertising - which was the most effective technique
 Your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley
that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is $.40 and the
put it in my mouth - which is a pretty personal place, after all - for a lousy dime?

In some businesses, the very nature of things is to sort of cascade toward the overwhelming dominance of
practically no city left in the U.S., aside from a few very big ones, where there's more than one daily newsp

Another advantage of scale comes from psychology. The psychologists use the term "social proof". We are
- by what we see others do and approve. Therefore, if everybody's buying something, we think it's better. W

Try to compete with a company that has an established distribution network. It has likely covered its fixed c
profits as it delivers more stuff, while you'll need to take on large losses for a time until (if) you gain enough
There are also disadvantages of scale. For example, we - by which I mean Berkshire Hathaway - are the larg
publications there that got murdered - where our competitors beat us. And the way they beat us was by go
Another defect of scale - flush, fat, stupid bureaucracy
in [a] rapidly globalizing world... with uncertain economic and political forecasts... And with increasingly he
rapid change favor flexibility and adaptability over sheer scale.
Can you describe
what thehow the business
customer’s worldoperates,
would look in like
yourwithout
own words?
the product or
service
Use an analogy to describe how the business operates
What is the business doing that the competitors are not doing yet?
How does the business make money?
If you can’t understand how a business makes money, then you should not invest in it.
How hasbusiness
the business evolved
evolved over acquisitions
by noting time? made and new product
developments from year to year.
In what foreign markets does the business operate, and what are the risks of operating in these countries?
How Long Has the Business Been Operating in the Foreign Market?
Is the Business Investing in R&D to Adapt Its Products to the Specific Tastes of the Customers in a Foreign M
Has the Management Team Assigned a Specific Regional Manager to Emerging Markets?
Is Revenue Growth Translating into Profit Growth?
What Are the Risks to a Company’s Foreign Earnings? - Country risk, currency risk,
Who is the core customer of the business?
Is the customer
A businessbase concentrated
that or diversified?
earns its revenues from a diversified customer base
has less risk than one with a concentrated customer base.
Is it easyhigh-
or difficult to convince
pressure customers
sales tactics to buy
to sell their the products
products or services?
or services typically do not have sustainable business mod
for the customer.
What is the customer retention rate for the business?
Customers who enroll in loyalty programs are typically repeat customers
Whether a business is selective about the types of customers it will do business with.
What are the signs a business is customer oriented?
How doesif management
Find out stay close
the business solves to customers?
customer problems quickly
and easily.
What pain does the business alleviate for the customer?
To what degree is the customer dependent on the products or services from the business?
If the business disappeared tomorrow, what impact would this have on the customer base?
Does the business have a sustainable competitive advantage and what is its source?

1. Network economics
2. Brand loyalty
3. Patents
4. Regulatory licenses
5. Switching costs
6. Cost advantages stemming from scale, location, or access to a unique asset
Does the business operate in a good or bad industry?
To beginisevaluating
If there the industry,
a broad range compare
of ROIC, with somethe distribution
companies of returns
doing well andon invested capital
some
To getdoing poorly,
a deeper this is a tougher
understanding industry
of whether antoindustry
be in. is good
or bad, compare the best companies to the worst within the industry.
How has the industry evolved over time?
What is the competitive landscape, and how intense is the competition?
Does the Business Have Limited Competition?
Does the Industry Change Often?
How Do the Competitors Compete within an Industry, and How Could That Change?
How Fiercely Do Businesses Compete?
What Risks Does the Business Face from Substitute Products?
Can Competition from Low- Cost Countries Impact the Business?
Which Competitor Sets the Industry Standard?
Why Have Competitors Failed in an Industry?
What type of relationship does the business have with its suppliers?
Does the Business Have Reliable Sources of Supply?
Is the Business Dependent on Only a Few Suppliers?
Is thebecause
Businessyou
Dependent
must assumeon Commodity Resources,
a certain price for theand to What in
commodity Degree?
the
future.
What are the fundamentals of the business?
What are the key risks the business faces?
How does inflation affect the business?
To what degree is the business cyclical, countercyclical, or recession-resistant?
Does the business grow through mergers and acquisitions (M&A), or does it grow organically?
What is the management team’s motivation to grow the business?
Has historical growth been profitable and will it continue?
What are the future growth prospects for the business?
How does management make M&A decisions?
Have past acquisitions been successful?
Creating value not beating rivals is at the heart of competition
In an unregulated commodity business, a company must lower its costs to competitive levels or face extinction.
In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competi
 If rivalry is intense companies compete away the value they create - in lower prices or higher costs of competi
Are their many competitors roughly equal in size
Slow growth promotes battle over market share
High exit barriers - excess capacity can lower profitabiliy
Rivals who are irrationally commited to the business
Price competition is the most damaging form of rivalry - you are competing to be the best. It happens when
Undifferentiated offering and low switching cost
High fixed cost and low marginal cost - creating pressure to drop prices as every new customer will cons
Capacity must be added in high increments - creating supply demand misbalance
Product that is perishable - e.g airline seats
If you have competitive advantage it means you compete at lower prices or premium price or both
Any Cumulative Advantage? - like a relationship
The two types of competitive advantage in the business world are created by producing a unique product and by pr
years from now and has been selling for past 10 years
Three basic types of businesses with durable competitive advantages:
1. Businesses that fulfill a repetitive consumer need with products that wear out fast or are used up
quickly, that have brand-name appeal, and that merchants have to carry or use to stay in business. This is a
huge world that includes every thing from cookies to panty hose.
2. Businesses that provide repetitive consumer services that people and businesses are consistently in need
of. This is the world of tax preparers, cleaning services, security services, and pest control.
3. Low-cost producers and sellers of common products that most people have to buy at some time in their
life. This encompasses many different kinds of businesses from jewelry to furniture to carpets to insurance.

Second- level thinking is deep, complex and convoluted. The second level thinker takes a great many things into acc
• What is the range of likely future outcomes?
• Which outcome do I think will occur?
• What’s the probability I’m right?
• What does the consensus think?
• How does my expectation differ from the consensus?
• How does the current price for the asset comport with the consensus view of the future, and with mine?
• Is the consensus psychology that’s incorporated in the price too bullish or bearish?
• What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

A textile company that allocates capital brilliantly within its industry is a remarkable textile company-but not a rem
Getting the story is easier if you understand the basic business. The simpler it is, the better. "An idiot could run this
running it.
1) It sounds dull, or even better, ridiculous-The perfect stock ought to have a perfectly boring name.
2) It does something dull- It does something boring, like make cans and bottle caps.
3) It does something disagreeable - A stock that makes people shrug, or turn away in disgust is ideal.
4) It's a spin off - The institutions don't own it, and the analysts don't follow it
5) The rumors abound: It's involved with toxic waste and/or the mafia
6) There's something depressing about it
7) It's a no-growth industry
People have to keep buying it
user of technology - as technology is advanced and becomes cheaper, costs are reduced

If you find a stock with little or no institutional ownerships, you've found a potential winner. Find a company that n
knowing about, and you've got a double winner.
For every single product in a hot industry, there are a thousand MIT graduates trying to figure out how to make it c
coupon-clipping services, oil-drum retrieval, or motel chains.
Niche means there is little or no competition. People can buy jewelery from anywhere - internet, out of state, acros
franchises are a niche, they have value. You can raise the price with an exclusive franchise. Newspapers used to be
niches, since no one else can make their drug. Chemical companies have niches because getting a poison approved
Marlboro.

In general, corporate insiders are net sellers, and they normally sell 2.3 shares to every one share that they buy. Wh
minimum, the company will not go bankrupt in the next six months. Long term,when management owns stock, the
significant when employees at lower echelons add to their positions. if you see someone with a $45,000 annual sal
meaningful vote of confidence

Depending on the pace of growth or the timing of business cycle, companies can be grouped into 6 categories. The
Slow Growers: Big companies that grow at a very minimal rate. The only reason to keep them is for the regular divi
Stalwarts: Big companies that grow faster than a Slow Grower but not as rapidly as a Fast Grower. They are less vol
downturn.
Fast Growers: These are small companies that grow at a high rate. You make money in stock market if you are able
growth peaks, a Fast Grower either turns to a Stalwart or fizzle out.
Turnarounds: These are companies that have gone through a series of negative events and which are bouncing bac
ground very quickly. In addition the ups and downs of these companies are totally unrelated to the market conditio
Cyclicals: The fortune
of these cyclicals may be big companies and could easily be confused with Stalwarts. However what differentiate cy
conditions, companies like TISCO, Auto makers, Banks, Infra companies like L&T and most of the Industrials like Cro
important to know when to get in to these stocks and when to get out of them.
Asset Plays: These are companies holding significant assets in their books of which the market is not aware of. Som
Carry forward losses which provide tax benefits to the company, Investments in the shares of other companies, hug

'Two minute drill'. Take two minutes of your time and make a case as to why you are interested in the company an
a sound case for investing in the specific stock. The author recommends us to follow this process even for the stock
Never investment in any idea you can’t illustrate with crayons
“If you like the store, chances are you’ll love the stock.” In other words: Invest in businesses you understand and w
The problem with good industries are that they attract competition. These new market participants crave a piece o
pressure. Peter’s binoculars are thus directed at terrible industries. Next, he attempts to find the ‘winner’ in said in
hence enabling them to ride-out cyclical waves while the competitors throw in the towel. Once the industry betters
dead companies’ market shares.

During the Gold Rush, most would-be miners lost money, but people who sold them picks, shovels, tents and blue-
Visiting stores and testing products is one of the critical elements of the analyst’s job
Max-Min of 1-2 variables -Business success through extreme maximization or minimization of 1 or 2 variables
In business we often find that the winning system goes almost ridiculously far in maximizing and or minimizin
The Network effect results from positive feedback, where success begets success and economies of scale undermin
The bottom line is that you're most likely to find the network effect in businesses based on sharing informatio
deal in rival (physical) goods... this is not exclusively the case, but it's a good rule of thumb.
If a product or service is widely and conveniently available, consumers are less likely to try the competition. Furthe
advantage of the easy availability.
Since there is only one cost leader, this is a powerful position for a company to hold.
As the product tends to commodity status, with price becoming the major issue for the buyer, the competitive p
in all shapes and sizes. Consider, for example, banks and the advantage of having the lowest cost of funds.

A good business model answers Peter Drucker’s age-old questions: Who is the customer? And what does the custo
manager must ask: How do we make money in this business? What is the underlying economic logic that explains h
Creating a business model is, then, a lot like writing a new story. At some level, all new stories are variations on old
experience. Similarly, all new business models are variations on the generic value chain underlying all businesses. B
the activities associated with making something: designing it, purchasing raw materials, manufacturing, and so on.
something: finding and reaching customers, transacting a sale, distributing the product or delivering the service. A n
product for an unmet need, as it did with the traveler’s check. Or it may turn on a process innovation, a better way
or service.

Keynes on stock picking as a beauty contest - “It’s not a case of choosing those [faces] that, to the best of one’s jud
opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anti
be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

“The difference between a good business and a bad business is that good businesses throw up one easy decision aft
“Frequently, you’ll look at a business having fabulous results. And the question is, “How long can this continue?” W
think about why the results are occurring now—and then to figure out what could cause those results to stop occur

“If you are in a business selling white paper for a dollar a pound, and your competitor sells it for a little less, I am pr
are selling me a glass of Johnnie Walker whisky for a dollar, and your competitor sells a glass of Uncle Joe’s whisky
Walker”
“There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second
never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We h
“If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re
mediocre result you’re going to get compared to the people who do have the temperament, who can be more phil
Characteristics of good businesses
 High Barriers to Entry
 High Margins
 Good management
 Pricing Power

What are some barriers to entry?

 High switching costs
 High capital costs
 Brands
 Lower operating costs (airline with 1 low cost fleet, by operating in a certain way, locks you in)
 Tobacco with its addicted customers
I would define a good business where you can identify specifically a reason why it should be able to earn an excess
you can clearly see. Typically, good businesses where you are seeing that on a consistent basis, you rarely see them

Operators of multi-sided platforms must ask themselves several key questions: Can we attract sufficient numbers o
price sensitive? Can that side be enticed by a subsidized offer? Will the other side of the platform generate sufficien

What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don
only have to be able to evaluate companies within your circle of competence. The size of that circle is
not very important; knowing its boundaries, however, is vital.

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that g
decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” ap
only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit. Unle
businesses is foolish. Unless you are a liquidator, you may end up waiting a long time for that “puff” of profit. (so bu
Good business - Something that costs a penny, sells for a dollar and is habit forming.
Find a business any idiot could run because eventually one will.
If share of mind exists, the market will follow
You can learn a lot about the durability of the economics of a business by observing price behavior
It is important to know the one or two key factors in each business you own.

Experience, however, indicates that the best business returns are usually achieved by companies that are doing som
years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve serv
obviously these opportunities should be seized. But a business that constantly encounters major change also encou
terrain that is forever shifting violently is ground on which it is diffi cult to build a fortress - like business franchise.

If it is not knowable, as you know there are all kinds of things that are important but not knowable, we forget abou
won't make any difference. We don't care. But there are enough things that are knowable and important that we fo

Economic analysis is basically marginal analysis. Marginal means additional. Economic theory is marginal analysis be
weighing additional costs against additional benefits. Nothing matters in decision making except marginal costs and
passenger may be $500, the marginal cost is merely the extra bag of peanuts and a drink. As long as the marginal p
is profitable.
The cost of any action is the value of the opportunity forgone by taking that action.Resources have other opportun
'crowd out' the next best application. Only actions have costs. One must do something to incur the cost. And costs
Reductionism is the cornerstone of discovery in the Newtonian world, the basis for much of science's breathtaking
scientist John Holland explains, 'The idea is that you could understand the world, all of nature, by examining smalle
would explain the whole.' In many systems reductionism works brilliantly.
But reductionism has its limits. In systems that rely on complex interactions of many components, the whole s
from the aggregation of the underlying components. Since the whole of the system emerges from the interac
simply by looking at the parts. Reductionism fails.
Every new era is marked and measured by key abundances and scarcities
In an information-rich world, the wealth of information means a dearth of something else: a scarcity of whate
consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates
efficiently among the overabundance of information sources that might consume it.
The key thing in economics, whenever someone makes an assertion to you, is to always ask, "And then what?" Actu
should always ask, "And then what?"
The 80/20 Principle- It simply maintains that a minority of causes, inputs, or effort usually lead to a majority of the
80/20, a significant imbalance is often found in a myriad of situations.
What is strategy but resource allocation? When you strip away all the noise, that's what it comes down to. Strategy
cannot be everything to everybody, no matter what the size of your business or how deep its pockets.
Always ask where the competition might come from; and examine substitutable products. The customer group ofte

Do not focus on the product, rather keep focusing on the people who consume it (or don’t consume it) and their ch
always buys to accomplish something.
If you weren't already in this business would you enter it today? If not, what are you going to do about it?
Core Competence - As a company moves along a product (or process) path, knowledge is accumulated. Since most
company is able to further innovate, and therefore move quicker, along this chosen path. Companies that have dev
make it more difficult for a new entrant to compete.
Competitive advantage through people -There are several problems with seeking competitive advantage through in
is proprietary - the people who sell you robots or point-of-sale terminals or software to analyze production or servi
competitors. Your ability to obtain the benefits of, let alone get any advantage from, this technology - which is ofte
ability to implement it more rapidly and more effectively. This almost inevitably involves the skill and motivation of

Specialization - Adam's smith pin factory

These waves of technology, you can see them way before they happen, and you just have to choose wisely which o
waste a lot of energy, but if you choose wisely, it actually unfolds fairly slowly. It takes years. One of our biggest ins
business where we didn't own or control the primary technology, because you'll get your head handed to you. We
primary technology was going to be software. And we were pretty good at software.

The great lesson in microeconomics is to discriminate between when technology is going to help you (only newspap
Water shapes its course according to the nature of the ground over which it flows; the soldier works out his victory
What can the company do, that the other competitors will not be able to do?
The company must recognize that the world in which it is operating is changing at an ever-increasing rate.
High margins attract competition, and competition erodes profit opportunities. The best way to mute competition
potential entrant.
It is hard to introduce new, superior products in market arenas where established competitors already have a stron
marketing power, and reputation to be competitive, existing competitors can take strong defensive actions to regai
success if they combine technology disciplines, e.g., electronics and nucleonics, in a way that is
novel relative to existing competitive competencies.

Technology is just one avenue to industry leadership. Developing a consumer “franchise” is another. Service excelle
Whatever the case, a strong ability to defend established markets against new competitors is essential for a sound
The minute the business starts contracting, significant assets are not there. Under social norms and the new legal r
the minute the enterprise goes into reverse, some of the assets on the balance sheet aren't there anymore.
We realized that some company that was selling at 2 or 3 times book value could still be a hell of a bargain because
with an unusual managerial skill plainly present in some individual or other, or some system or other.
If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much d
huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive look

However, averaged out, betting on the quality of a business is better than betting on the quality of management. In
momentum, not the brilliance of the manager. But, very rarely, you find a manager who's so good that you're wise
In fact, any time anybody offers you anything with a big commission and a 200-page prospectus. don't buy it. Occas
However, over a lifetime, you'll be a long way ahead - and you will miss a lot of unhappy experiences that might oth

There are actually businesses. that you will find a few times in a lifetime, where any manager could raise the return
just by raising prices - and yet they haven't done it. So they have huge untapped pricing power that they're not usin
such a unique experience to take your grandchild to Disneyland. You're not doing it that often. And there are lots o
those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells was utter brill
and Disneyworld and through video cassette sales of classic animated movies.

At Berkshire Hathaway, Warren and I raised the prices of See's Candy a little faster than others might have. And, of
pricing power. And it also had brilliant management. So a Goizueta and Keough could do much more than raise pric

The Washington Post - we bought it at about 20% of the value to a private owner. So we bought it on a Ben Graham
faced a situation where you had both the top hand in a game that was clearly going to end up with one winner and
was a real dream. They're very high class people - the Katharine Graham family. That's why it was a dream - an abso

And in Gillette's case, they keep surfing along new technology which is fairly simple by the standards of microchips.
hard for competitors to do. So they've been able to stay constantly near the edge of improvements in shaving. Ther
shaving market.
And GEICO had a perfectly magnificent business - submerged in a mess, but still working. Misled by success, GEICO
because they were making a lot of money, they knew everything. And they suffered huge losses. All they had to do
wonderful business that was lying there. And when you think about it, that's a very simple model. And it's repeated
Obviously there are industries where two brands can co-exist like Ford and Chevrolet, but there are others like new
other. That’s just the way it is. It’s hard to predict what will happen with two brands in a market. Sometimes they w
each other. I know of no way to predict whether they’ll compete moderately or to the death. If you could figure it o
The definition of a great company is one that will be great for 25 to 30 years.
Even a third-rate newspaper can generate adequate profits if it is the only paper in town. In addition to their franch
As Buffett points out, newspapers have low capital needs, so they can easily translate sales into profits. Newspaper
generating above-average returns on invested capital and reducing the harmful effects of inflation.
Buffett figures that a typical newspaper could double its price and still retain 90 percent of its readership.

Take the probability of loss times the amount of possible loss from the probability of gain times the amount of poss
Investment is an activity of forecasting the yield on assets over the life of the asset; speculation is the activity of for
If you're an investor, you're looking at what the asset—in our case, businesses—will do. If you're a speculator, you'
of the business.
Product differentiation and strong brand are not the same as a profitable franchise
Value of a brand is equal to the cost that it took to create the brand then branding by itself is not a source of value
Value is only created when incumbents have abilities that new comers cannot match
As long as newcomers can develop and distribute new products on an equal footing with incumbents all products e
Simplest form of competitive advantage is government franchise - cable franchise, broadcast television, telephone
Other competitive advantage is being a low cost producer- due to a patent, know-how, access to cheap resources,
There are situations where incumbents are at a cost disadvantage- where technology is changing rapidly
High switching cost can limit the arrival of new entrants
Economies of scale - high fixed cost and low variable cost e.g. shrink - wrapped software
Consumer franchise that are sustainable over decades must have a competitive advantage in recruiting new custom
The problem of declining profits in the face of increased price competition has challenged thousands of companies
other players. It is a truth universally acknowledged that all sensible people abhor commodity businesses. The stan
product or service from all the others.
Globalization of the luxury car market proved to be profitability's foe. Both in theory and in practice, product differ
franchise.
These three concepts-franchises, barriers to entry, and incumbent competitive advantages-amount to the same thi
of any value that exceeds the cost of reproducing a firm's assets.
In an open and competitive economy, there are only a limited number of ways in which customer behavior leads to
frequency, is probably the most powerful.
High switching costs are the most common source of customer captivity. If it costs money, time, and effort for a cus
have an advantage over entrants. For example, when a company changes software systems for payroll, benefits ma
important functions, the company has to spend not only on the software but also on extensive retraining of the sta
installation still goes up. The corporate graveyard is filled with firms that bet the business on introducing a new, im

In order for economies of scale to be worth something and have implications for the valuation of a particular comp
advantages that provide the company with a predominant share of the market in question. By themselves, econom
advantages.
Those that do not capitalize on their protected positions may be concealing substantial value in unused pricing pow
Rapid change in technology will often mean that, in the absence of economies of scale, cost structure advantages a
are long lasting, patents do expire, learning curves flatten, and the associated competitive advantages still disappea
range of technological environments-change not too fast and not too slow and even they have limited lives.
The HMO that has a 60 percent share of households in the New York metropolitan area will be able to benefit from
considerably larger HMOs with 30 percent shares of the Chicago, Miami, Dallas, San Diego
Structural competitive advantages come in only a few forms: exclusive governmental licenses, consumer (demand)
patents or other durable superiorities, and the combination of economies of scale thanks to a leading share in the r
The history of the luxury car market suggests that this kind of brand-mediated pricing power does not create a sign
ravages of competition. Even a marque as illustrious as Mercedes-Benz is not a major competitive advantage in this

The brand may be an essential element of the perceived value of the product. But by itself the brand does not cons
create a franchise. The aspects of consumer behavior that do create franchise value are those we have described in
to customer captivity.
Also, the value of brands is greatly enhanced by the presence of economies of scale. A sticker on a computer that s
but when accompanied by powerful economies of scale in chip design and production, even a weak brand becomes

Dealmaking beats working. Dealmaking is exciting and fun, and working is grubby. Running anything is primarily an
romantic, sexy. That’s why you have deals that make no sense.”
I don’t think anyone should buy a bank if they don’t have a feel for the bankers. Banking is a business that is a very
away.”
ts simply are hurt the least.
es of Costco

cisions time after time.”

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FINANCE
In many businesses-particularly those that have high asset/profit ratios-inflation causes some or all of the reported
The ersatz portion-let's call these earnings "restricted"-cannot, if the business is to retain its economic positio
The first point to understand, is that not all earnings are created equal
For every dollar retained by the corporation, at least one dollar of market value will be created for owners.
This will happen only if the capital retained produces incremental earnings equal to, or above, those generally
Outstanding businesses by definition generate large amounts of excess cash.
Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often.
Major repur- chases at prices well below per-share intrinsic business value immediately increase, in a highly s
purchase their own stock, they often find it easy to get $2 of present value for $1.
Earnings can be as pliable as putty when a charlatan heads the company reporting them. Eventually truth will surfa
The goal of each investor should be to create a portfolio (in effect, a "company") that will deliver him or her the hig
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital
gimmickry, etc.) and not the achievement of consistent gains in earnings per share.
Managers and investors alike should view intangible assets from two perspectives:
(1) In analysis of operating results-that is, in evaluating the underlying economics of a business unit-amortizati
can be ex- pected to earn on unleveraged net tangible assets, exclud- ing any charges against earnings for am
economic attractiveness of the operation. It is also the best guide to the current value of the operation's econ

(2) In evaluating the wisdom of business acquisitions, amorti- zation charges should be ignored also. They sho
from the cost of the business.This means forever viewing purchased Goodwill at its full cost, before any amor
including the full intrinsic business value-not just the recorded accounting value-of all con- sideration given, ir
involved at the time of merger and irrespective of whether pooling treatment was allowed. For example, wha
of the Goodwill of See's and the News was considerably more than the $51.7 million entered on our books. Th
the Berkshire shares given up in the merger was less than their intrinsic busi- ness value, which is the value th

Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business durin
Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if
Does the company have a worthwhile profit margin?
What is the company doing to maintain or improve profit margins?
In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger num
the existing stockholders’ benefit from this anticipated growth?
The promised benefits from these textile investments were illusory. Many of our competitors, both domestic and fo
expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices indu
capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each
when each person watching a parade decides he can see a little better if he stands on tiptoes. After each round of i
the game and returns remained anemic

Is the business’s balance sheet strong or weak?

Are the accounting standards that management uses conservative or liberal?
Does the business generate revenues that are recurring or from one- off transactions?
To what degree does operating leverage impact the earnings of the business?
How does working capital impact the cash flows of the business?
Does the business have high or low capital- expenditure requirements?
Have the managers been buying or selling the stock?
Do the CEO and CFO issue guidance regarding earnings?
Once a business begins to set guidance, it may also adopt a short- term outlook at the expense of long- term g
Does the management team focus on cutting unnecessary costs?
Are the CEO and CFO disciplined in making capital allocation decisions?
Do the CEO and CFO buy back stock opportunistically?
EBITDA is bullshit earnings
“In financial terms it's easy to describe a high-quality business. They generate high returns on unlevered capital and
They produce free cash flow or have attractive enough reinvestment opportunities to invest cash flow at high retur
Steady cash flows comes from one reason or another, from indespensability of companys products - either from br
Best kind of business to own is one with high profit margins and high inventory turnover. Second-best kind of busin
or achieve enough inventory turnover to compensate for lower profit margins
Stock splits have three consequences: they increase transaction costs by promoting high share turnover; they attra
oriented views who unduly focus on stock market prices; and, as a result of both of those effects, they lead to price
value

Company that sells its stock at a price less than its value is stealing from its existing shareholders.
Sellers in stock acquisitions measure the purchase price by the market price of the buyer's stock, not by its intrinsic
equal to, say, half its intrinsic value, then a buyer who goes along with that measure gives twice as much in busines
rationalizing his or her actions by arguments about synergies or size, is elevating thrill or excessive optimism above

Acquisitions paid for in stock are too often (almost always) described as "buyer buys seller" or "buyer acquires selle
follow from saying "buyer sells part of itself to acquire seller," or something of the sort
Best value-enhancing transactions requires concentrating on opportunity costs, measured principally against the al
businesses through stock market purchases. Such concentration is alien to the manager obsessed with synergies an
It is common on Wall Street to value businesses using a calculation of cash flows equal to (a) operating earnings plu
charges. Buffett regards that calculation as incomplete. After taking (a) operating earnings and adding back (b) non-
subtract something else: (c) required reinvestment in the business. Buffett defines (c) as "the average amount of ca
etc., that the business requires to fully maintain its long-term competitive position and its unit volume." Buffett call

When (b) and (c) differ, cash flow analysis and owner earnings analysis differ too. For most businesses, (c) usually e
overstates economic reality.
If options aren't a form of compensation, what are they? If compensation isn't an expense, what is? And, if expense
where in the world should they go?"
Parochial positions on accounting can be economically disastrous, as the debate over accounting for retiree health
promised to pay for health care services to retired employees were not required by GAAP to record the associated
thus made it easy to make such financial commitments, and many businesses made far more generous commitmen
would have had they been required to report the obligation. One consequence was a wave of bankruptcies, as busi
maturing obligations.
Policies of the corporation in attracting shareholders to those of a restaurant attracting potential customers. A rest
fast foods, elegant dining, Oriental food, etc.-and eventually obtain an appropriate group of devotees. If the job we
the service, menu, and price level offered, would return consistently. But the restaurant could not change its chara
stable clientele. If the business vacillated between French cuisine and take-out chicken, the result would be a revol
Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets t
deferred taxes and "float," the funds of others that our insurance business holds because it receives premiums befo

Most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality
be safe. It’s just a matter of the price paid for them.
An excellent investor may be one who— rather than reporting higher returns than others— achieves the same retu
less risk (or even achieves a slightly lower return with far less risk). Of course, when markets are stable or rising, we
entailed. That’s what’s behind Warren Buffett’s observation that other than when the tide goes out, we can’t tell w
naked.

Diversification is effective only if portfolio holdings can be counted on to respond differently to a given developmen
Risk control lies at the core of defensive investing. Rather than just trying to do the right thing, the defensive invest
wrong thing. Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing
what balance to strike between the two. The defensive investor chooses to emphasize the former.

Hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisf
is competent and honest, and the market does not overvalue the business.
To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will ind
(2) How long will your money be tied up? (3) What chance is there that something still better will transpire-a comp
bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing g
The other way we differ from some arbitrage operations is that we participate only in transactions that have been p
or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go
The primary factors bearing upon this (equtiy investment) evaluation are:
1) The certainty with which the long-term economic characteristics of the business can be evaluated;
2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the b
3) The certainty with which management can be counted on to channel the reward from the business to the shareh
4) The purchase price of the business;
5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an inves
his gross return.

The theoretician bred on beta has no mechanism for differentiating the risk inherent in, say, a single-product toy co
of another toy company whose sole product is Monopoly or Barbie
By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most in
"dumb" money acknowledges its limitations, it ceases to be dumb.
Growth is always a component in the calculation of value, constituting a variable whose importance can range from
be negative as well as positive.
Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on valu
one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured
finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off
industry has grown, the worse the disaster for owners.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing-in oth
the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremen

Searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twe
environment may offer the chance for huge wins, but it precludes the certainty we seek.
Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandabl
to be materially higher five, ten and twenty years from now.
A great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, prob
American Express and GEICO.
The banking business is no favorite of ours. When assets are twenty times equity-a common ratio in this industry-m
assets can destroy a major portion of equity.

Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger
be expected to make its driver proceed with intensified care. We'll acknowledge that such an attention-getter wou
certain consequence would be a deadly-and unnecessary-accident if the car hit even the tiniest pothole or sliver of
potholes; a plan that requires dodging them all is a plan for disaster.
We suspect three motivations-usually unspoken to be, singly or in combination, the important ones in most highpre
takeovers:
(1) Leaders, business or otherwise, seldom are deficient in animal spirits and often relish increased activity and cha
beats faster than when an acquisition is in prospect.
(2) Most organizations, business or otherwise, measure themselves, are measured by others, and compensate thei
by any other yardstick. (Ask a Fortune 500 manager where his corporation stands on that famous list and, invariabl
ranked by size of sales; he may well not even know where his corporation places on the list Fortune just as faithfull
profitability.)
(3) Many managements apparently were overexposed in impressionable childhood years to the story in which the i
toad's body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonder

During an inflationary period, companies with a core business characterized by extraordinary economics can use sm
business at very high rates of return. But, unless they are experiencing tremendous unit growth, outstanding busine
excess cash. If a company sinks most of this money in other businesses that earn low returns, the company's overal
appear excellent because of the extraordinary returns being earned by the portion of earnings incremental investe

While deals often fail in practice, they never fail in projections-if the CEO is visibly panting over a prospective acqui
the requisite projections to rationalize any price.
Current earnings per share (or even earnings per share of the next few years) are an important variable in most bus
far from all-powerful.

The sad fact is that most major acquisitions display an egregious imbalance: They are a bonanza for the shareholde
status of the acquirer's management; and they are a honey pot for the investment bankers and other professionals
wealth of the acquirer's shareholders, often to a substantial extent. That happens because the acquirer typically giv
Accounting numbers are the beginning, not the end, of business valuation.
A business may be well liked, even loved, by most of its customers but possess no economic goodwill. (AT&T, befor
but possessed not a dime of economic Goodwill.) And, regrettably, a business may be disliked by its customers but
Goodwill.
When we purchased See's in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible a
mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal op
assets, that mundane business would possess little or no economic Goodwill.
A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In con
though it had no more in earnings and less than half as much in "honest-to-God" assets. Could less really have been
answer is "yes"-even if both businesses were expected to have flat unit volume- as long as you anticipated, as we d
To understand why, imagine the effect that a doubling of the price level would subsequently have on the two busin
earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the sam
assuming profit margins remain unchanged, profits also must double.
But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net
economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales m
employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to
this inflation-required investment will produce no improvement in rate of return. The motivation for this investmen
prosperity of the owner.
Remember, however, that See's had net tangible assets of only $8 million. So it would only have had to commit an
imposed by inflation. The mundane business, meanwhile, had a burden over twice as large-a need for $18 million o
the mundane business, now earning $4 million annually, might still be worth the value of its tangibleassets, or $36
gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they w
a savings account.)
See's, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same b
would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capi
invested.

Asset-heavy businesses generally earn low rates of return, rates that often barely provide enough capital to fund th
with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose fr
of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In s
nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phen
communications business. That business has required little in the way of tangible investment-yet its franchises have
that keeps giving.

Assume a company with $20 per share of net worth, all tangible assets. Further assume the company has internally
franchise, or that it was fortunate enough to obtain some important television stations by original FCC grant. There
$5 per share, or 25%. With such economics, it might sell for $100 per share or more, and it might well also bring tha
business.
Assume an investor buys the stock at $100 per share, paying in effect $80 per share for Goodwill Just as would a co
Should the investor impute a $2 per share amortization charge annually ($80 divided by 40 years) to calculate "true
"true" earnings of $3 per share cause him to rethink his purchase price?
Most managers probably will acknowledge that they need to spend something more than (b) on their businesses ov
terms of both unit volume and competitive position. When this imperative exists-that is, when (c) exceeds (b) GAAP
this overstatement is substantial. The oil industry has in recent years provided a conspicuous example of this pheno
only (b) each year, they would have guaranteed their shrinkage in real terms.

Absurdity of the "cash flow" numbers that are often set forth in Wall Street reports. These numbers routinely includ
brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business b
the Pyramids-forever state-of-theart, never needing to be replaced, improved or refurbished. Indeed, if all U.S. corp
sale through our leading investment bankers-and if the sales brochures describing them were to be believed-gover
equipment spending would have to be slashed by 90%.

"Cash Flow," true, may serve as a shorthand of some utility in descriptions of certain real estate businesses or othe
that make huge initial outlays and only tiny outlays thereafter. A company whose only holding is a bridge or an extr
gas field would be an example. But "cash flow" is meaningless in such businesses as manufacturing, retailing, extrac
(c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. Bu
the investment-or the business decays.

Why, then, are "cash flow" numbers so popular today? In answer, we confess our cynicism: we believe these numb
used by marketers of businesses and securities in attempt to justify the unjustifiable (and thereby to sell what shou
unsalable). When (a)-that is, GAAP earnings-looks by itself inadequate to service debt of a junk bond or justify a foo
salesmen to focus on (a) + (b). But you shouldn't add (b) without subtracting (c): though dentists correctly claim tha
same is not true for (c). The company or investor believing that the debt-servicing ability or the equity valuation or
and (b) while ignoring (c) is headed for certain trouble.

The greater the number of economically diverse business operations lumped together in conventional financial stat
In the case of unregulated businesses blessed with strong franchises: the corporation and its shareholders are then
In the price-competitive industry, whose companies typically operate with very weak business franchises. In such in
profits in a delayed and irregular, but generally effective, manner. The marketplace, in effect, performs much the sa
competitive industry as the Public Utilities Commission does in dealing with electric utilities. In these industries, the
more than profits.

Return-on-capital metrics measure the effectiveness of a company’s capital allocation decisions and are also arguab
positioning and competitive advantages. Theoretically, returns on capital should equal the opportunity cost of capit
economic profit normally draws competition, and competitive pressure gradually erodes profitability to erase econ
markets, companies earn no economic profit. To achieve sustained high returns on capital requires possessing feat
namely, competitive advantages.
Three elements drive corporate cash return on investment: asset turns, profit margins and cash conversion. Asset t
generates sales from additional assets, which can vary greatly depending on the asset intensity of the industry itsel
incremental sales; and cash conversion reflects a company’s working capital intensity and the conservatism of its ac

The simplest and most commonly used tool for measuring returns is return on equity: net income as a percentage o
proxy, the figure is crude for two reasons. Most obviously, the return part of the equation uses accounting measure
considerable discretion over the treatment of important measures such as depreciation and provisioning. The calcu
the value of shareholders’ equity, such as write-downs and debt levels.
Measures such as return on invested capital (measured as net after-tax operating profit divided by invested capital
is a metric zeroing in on cash returns on cash capital invested (CROCCI);this is measured as after-tax cash earnings d
accounting conventions such as amortization of goodwill. CROCCI measures the post-tax cash return on all capital a

Asset-light industries are attractive since they require less capital to be deployed in order to generate sales growth.
such as Domino’s Pizza, where growth is funded by franchisees rather than by the company. Other instances includ
Systèmes, a leading European developer of design software.
Although gross margin is a partial function of a company’s industry and high gross margins can reflect low asset inte
relative to industry peers tends to indicate durable competitive advantage. Businesses with high operating margins
ones. A company that consistently achieves both high gross and high operating margins indicates a strong competi

Opportunities for growth maximize the benefits derived from high returns on capital. Such opportunities can arise f
or through a firm grabbing share from rivals in existing markets or expanding geographically. The very best compan
through ingenuity in the design of products, pricing, and product mix.
A more common source of growth comes through price/mix optimization. For example, a boxed chocolate maker m
premium package and increase its price by more than its additional cost. As total revenues rise, the excess increase

Five ways a company can increase earnings:

1) Reduce costs
2) Raise prices - You can raise the price with an exclusive franchise.
3) Expand into new markets
4) Sell more of its product in old markets
5) Revitalize, close or otherwise dispose of a losing operation
Avoid "diworseifications" - "Instead of buying back shares or raising dividends, profitable companies often prefer to
dedicated diworseifier seeking out merchandise that is (1) overpriced and (2) completely beyond his or her realm o
maximized."
The company that sells 20 to 25 percent of its wares to a single customer is in a precarious situation.... short of can
leverage in extracting price cuts and other concessions that will reduce the supplier's profits. it's rare that a great in
arrangement.
Percent of Sales' tells you how much percentage a specific product is contributing to the overall revenue of the com
The cash position also tells you the floor to which the stock price could fall. When it comes to Cash Position, it is als
proposing to do with the cash that it has got.
If the business dividends out all free cash flow, a long-term shareholder will earn a return equal to the free cash flo
The return on capital earned by the business is irrelevant when the payout ratio is 100 percent. As the payout ratio
becomes increasingly important.
I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punc
got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at a
There is a huge amount of difference between business that requires a large amount of capital to grow and the bus
The CEO who misleads others in public would mislead himself in private
“[Projections] are put together by people who have an interest in a particular outcome, have a subconscious bias, a
Forecasts tell you a gread deal about the forecaster, they never tell you anything about the future
Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in la
withheld from owners. For example, ten-year, fixed-price stock options are granted routinely, often by companies w
earnings.
It’s fine for a CEO to have his own internal goals and, in our view, it’s even appropriate for the CEO to publicly expre
expectations are accompanied by sensible caveats. But for a major corporation to predict that its per-share earning
annually is to court trouble.
When things go bad, all kinds of things correlate that you wouldn’t think of. Buffett said this is deadly. If you are no
unrecognized concentration of risk
Why is the stock price depressed?
Are they selling below book value?
Is goodwill in book value?
What has been the high-low over past 10 years?
Have they any cash flow?
Have they any net income?
How have they done over the past 10 years?
What is their debt level?
What kind of industry are they in?
What are their profit margins?
How are their competitors doing?
Has the company done poorly with respect to their competitors?
How much is the downside and upside potential?
How much stocks do the insiders own?
What is the company product? Can the company continue selling it for years? Prefer product over service
Be aware of the level of stock market- are yields low and P-E ratios too high, are too many IPOs , are people overop
Does the company have a worthwhile profit margin?
Companies with less profit margin more rapidly increase their earnings in abnormally good years but they do
earnings will decline more rapidly when the business tide turns
Sometimes companies deliberately speed up growth by spending all of their earnings on even more research
What is the company doing to maintain or improve profit margins?
Wages and salaries go up every year, which in turn affect raw material and supplies cost, as a result profit mar
Some companies maintain profit margins by rasising prices but that is temporary
Some companies maintain margin by capital improvement or product engineering department - to reduce cos
The intrinsic value of a firm is either the reproduction costs of the assets, which should equal the EPV, or those asse
that underlie its franchise
The only growth that creates value is growth in markets where company enjoys a competitive advantage
Three slices of value - asset value, Earning power value, value of growth
The more common condition that explains an EPV that is greater than asset value is when a firm enjoys substantial
The value of franchise lies not only in its current earning power but also in the possibilities for profitable growth. Th
instrinsic value is growth within the franchise growth that because of the competitive advantage of the firm can ea
suport it
New entrants will appear till the EPV becomes equal to the asset value
Intrinsic value estimates based on earnings are inherently less reliable than estimates based on assets.
When we consider economically viable industries, there are three possible situations. In the first, the firm's EPV ma
of its assets. In this case, management is not using the assets to produce the level of earnings that it should. The cu
doing. In the second, the EPV and the asset value are more or less equal. This is the situation we would expect to se
advantages. If a careful analysis of the structure of costs and customer demand supports this conclusion, then the a
and our confidence in both is increased. In the third situation, if the EPV, properly calculated, is significantly higher
we are looking at an industry setting in which there must be strong barriers to entry. Firms within the barriers will e
to the humbling experience of seeing new entrants join the party with no handicap for arriving late. For the EPV to
sustainable at the current level for the indefinite future.

The defining character of a franchise is that it enables a firm to earn more than it needs to pay for the investments
asset value; the difference between the two, as we said, is the value of the franchise. Therefore, the intrinsic value
assets, which should equal the EPV, or those assets plus the competitive advantages of the firm that underlie its fra

Situations in which growth has value arise when the firm's EPV substantially and sustainably exceeds its asset value
For a manufacturing firm, the more commodity-like the inventory, the less the discount necessary to sell it. It is tho
down, not the cotton yarn. If, on the other hand, the inventory consists of cartons of last year's unsalable toys, then
away. We estimate in this case that we can realize 50 percent on the inventory; if the inventory is highly specialized
substantially lower.

"Is goodwill worth anything?" - it all depends on the source of the goodwill, and for that we need information and i

Let's say we estimate the asset value of a company, after deducting spontaneous liabilities, at $100 million, and it h
the equity at $20 million. But if we are off by 10 percent, and the true value is $90 million, the value of the equity s
margin of safety may be eliminated and then some. Because leverage can be the foe of the margin of safety, many
have high levels of debt.
It is useful to think of liabilities as falling into three categories.
First are those liabilities that arise intrinsically from the normal conduct of the business: accounts payable to s
due to employees, accrued taxes due to governments, and other accrued expenses. Most of these are current
The second class of liabilities consists of those obligations that arise from past circumstances that are not perti
tax liabilities or liabilities incurred because of adverse legal judgments (e.g., our company broke the law and o
not relevant for the newcomer. The tax law may have changed, or this firm's experience may effectively deter
mistakes. Liabilities like these do not reduce the investment a potential entrant will have to make, but becaus
be paid, they do need to be subtracted from the asset value to see what this firm is worth to investors.

The third class of liabilities is the outstanding formal debt of the company. The appropriate treatment of the d
the reproduction cost of the assets and then subtract the first two categories of liabilities (spontaneous and w
with the asset value of the whole enterprise to which investors have claims. This value will be divided betwee
the equity. If we are shareholders or are looking to make an equity investment, we need to subtract the value
value of the debt, if available; if not, the book value is generally an adequate alternative
Finding the reproduction cost of a firm's assets and liabilities takes more work, more knowledge, and more everyth
figures.
Whenever an investment banker starts talking about EBDIT—or whenever someone creates a capital structure that
accrued, to be comfortably met out of current cash flow net of ample capital expenditures— zip up your wallet
The lower the government bond yield, the more valuable stocks will be, all else equal.
If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things alon
Our endorsement of repurchases is limited to those dictated by price/value relationships and does not extend to th
find odious and repugnant. In these transactions, two parties achieve their personal ends by exploitation of an inno
players are: (1) the “shareholder” extortionist who, even before the ink on his stock certificate dries, delivers his “y
managers; (2) the corporate insiders who quickly seek peace at any price—as long as the price is paid by someone e
is used by (2) to make (1) go away. As the dust settles, the mugging, transient shareholder gives his speech on “free
its speech on “the best interests of the company,” and the innocent shareholder standing by mutely funds the payo

Though historical volatility is a useful—but far from foolproof—concept in valuing short-term options, its utility dim
lengthens. In my opinion, the valuations that the Black-Scholes formula now place on our long-term put options ov
will diminish as the contracts approach maturity.

The efficient market hypothesis does not live or die by investor rationality. In many scenarios where some investors
predicted to be efficient. In one commonly discussed case, the irrational investors in the market trade randomly. W
and when their trading strategies are uncorrelated, their trades are likely to cancel each other out. In such a marke

Where you have complexity, by nature you can have fraud and mistakes. . . . This will always be true of financial com
you want accurate numbers from financial companies, you’re in the wrong world
y can change hands.
decade or so from now.

ure cash flows are revised.

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HR
Does the company have outstanding labor and personnel relations?
Relative labor turnover with respect to other companies
Realtive waiting list of candidates waiting to join a company
Above average profits while paying above average wages
Profit sharing and pension plans can play a role in improving relations
Good communication to and from from all levels of employees
Does the company have outstanding executive relations?
Does the company have depth to its management?
“In any big business, you don’t worry whether someone is doing something wrong, you worry about whether it’s bi
“ ‘One solution fits all’ is not the way to go. . . . The right culture for the Mayo Clinic is different from the right cultu
“The highest form that civilization can reach is a seamless web of deserved trust—not much procedure, just totally
another. . . . In your own life what you want is a seamless web of deserved trust.”
There must always be a conscious and continuous effort, based on fact, not propaganda, to have employees at eve
white-collar worker to the highest levels of management, feel that their company is a good place to work
o a lot to mitigate bad behavior, but you simply can’t prevent it altogether."
an’t run all these places with a cookie-cutter solution.”
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OPERATIONS
How good are the company’s cost analysis and accounting controls?
Institutional Imperative: (1) As if governed by Newton's First Law of Motion, an institution will resist any change in
fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business cra
quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of p
acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Braun's Five W's: Who, what, where, when and why.

If you tell people why, they'll be much more likely to comply.
What are the operating metrics of the business that you need to monitor?
One mistake many companies make is applying the same performance metrics to all their businesses and stra
a desire to please the financial markets… but these measures tend to be more appropriate for later-stage, ma
picture of newer, more experimental ventures.

In such businesses, milestone measures such as hiring a key executive, winning early customers, and meeting
Second, financial measures are often lagging indicators of the market’s feedback. Other, more operational me
time, sales per square foot, employee turnover, and rework time, when added to financial data, may provide

Does the management team improve its operations day- to- day or does it use a strategic plan to conduct its busine
Day to day improvement is better than a straightjacket strategic plan
Is the business managed in a centralized or decentralized way?
Centralized is typically more bureaucratic
“You’ve got a complex system and it spews out a lot of wonderful numbers that enable you to measure some facto
important, [yet] there’s no precise numbering you can put to these factors.”
We delegate to the point of abdication
Management changes, like marital changes are expensive, time consuming and chancy
Many corporate managers are told to submit budgets and quarterly estimates. This leads to a short-term focus and
does not want to let the boss down may fudge the numbers
He suggests the “newspaper” standard: behave as if your actions will be on the front page of the local newspaper.

A firm with a strong financial team has several important advantages:

a. Good cost information enables management to direct its energies toward those products with the highest poten
b. The cost system should pinpoint where production, marketing, and research costs are inefficient even in sub-par
c. Capital conservation through tight control of fixed and working capital investments.
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LEGAL AND GOVERNANCE
Many annual meetings are a waste of time, both for shareholders and for management. Sometimes that is true bec
matters of business substance. More often a non-productive session is the fault of shareholder participants who ar
stage than they are about the affairs of the corporation. What should be a forum for business discussion becomes a
advocacy of issues.

Relations between the Board and the CEO are expected to be congenial. At board meetings, criticism of the CEO's p
equivalent of belching. No such inhibitions restrain the office manager from critically evaluating the substandard ty
First, stock options are inevitably tied to the overall performance of a corporation. Logically, therefore, they should
responsibility. Managers with limited areas of responsibility should have incentives that payoff in relation to results

Second, options should be structured carefully. Absent special factors, they should have built into them a retained-
cost factor. Equally important, they should be priced realistically.
The combination of a ten-year option, a low dividend payout, and compound interest can provide lush gains to a m
in his job.
Investment risk is largely invisible before the fact— except perhaps to people with unusual insight— and even after
Having first-rate people on the team is more important than designing hierarchies and clarifying who reports to wh
Director power is weakest in the case where there is a controlling shareholder who is also the manager. When disa
management, there is little a director can do other than to object and, in serious circumstances, resign. Director po
there is a controlling shareholder who does not participate in management. The directors can take matters directly
disagreement arises.

The most common situation, however, is a corporation without a controlling shareholder. This is where manageme
most acute, Buffett says. It would be helpful if directors could supply necessary discipline, but board congeniality us
Many corporations pay their managers stock options whose value increases simply by retention of earnings, rather
Buffett explains, however, simply by retaining and reinvesting earnings, managers can report annual earnings incre
improve real returns on capital. Stock options thus often rob shareholders of wealth and allocate the booty to exec
are often irrevocable, unconditional, and benefit managers without regard to individual performance

Executive performance should be measured by profitability, after profits are reduced by a charge for the capital em
retained by it. If stock options are used, they should be related to individual performance, rather than corporate pe
Better yet, as at Berkshire, stock options should simply not be part of an executive's compensation. After all, excepti
on the performance of their own business can simply buy stock if they want to; if they do, they "truly walk in the sh

Earnings are often retained for non-owner reasons, such as expanding the corporate empire or furnishing operation
Buffett’s view is that the most important job of the board is to pick the right CEO. The second most important job is
often happens in acquisitions.
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SALES
BD is the finanl frontier, it involves seeing all the functions of both the parties
Does the company have an above average sales organization?
Sales is all about relationship - you like us and we like you - rest just follows - half of the time it boils down do -I don
Social exchange based on affirmation - thinking is based on negation - don’t make people think - don’t argue w
When dealing with people, let us remember we are not dealing with creatures of logic. We are dealing with cr
creatures bristling with prejudices and motivated by pride and vanity.
Smile - trade a smile with someone who is blue now (emotions are contagious) - when you smile the whole w
Remember names - name is the sweetest sound to a person - associate an image with a name
Make the conversation about the other person - listen - let the other person do a great deal of talking- talk ab
Interact - Interact - Interact - do not miss any chance of having a conversation
The only way on earth to influence other people is to talk about what they want and show them how to get it
Cognitive empathy - emotional empathy - empathic concern (seed of compassion)
Sales or BD funnel - take the client through different stages - AIDA - Cold, warm, hot, sold

Prospecting
Building rapport
Identifying needs
Presenting
Answering objections
Closing the sale
Getting resales and referrals

First, arouse in the other person an eager want.

Appeal to interest, not to reason - talk in terms of other people's interest
Logic makes people think, but it is emotion that makes then act
The fear of loss is often greater than the desire for gain - two main reason people buy or don’t buy are desire for
Connectors ( See every person as an opportunity), Maven and Salesman (exude enthusiasm about your product) - p
The most effective sales call is 25% talking / questioning and 75% listening
The prospect
People believeis more
persuaded more
of what theybysee
thethan
depth of your
what they conviction
hear. – usethan he is by the
testimonials height
- social of your logic.
proof

You are not selling what it is…you sell what it does. Prospects do not buy products. Prospects buy products of the p
Start your presentation with the strongest benefit and end with the second strongest benefit
Always ask for the order - AAFTO
Have an absolute and total belief that what you're selling is worth more than the price you ask for it. Your belief in
Mentally prepare yourself. Review your product knowledge and selling skills before every call. Try to write down yo
using too many words, that you drift away from the point, or that you are not specific enough. Writing will remind y
generate better selling ideas.

Use emotion and logic in your presentation. Logic makes people think; emotion makes them act.
You need to balance these keys. If you use all logic, you end up with the best-educated prospect in town. If you use
How to ask for referrals:
Ask your prospect if they would introduce you to their friend if he were here right now.
Ask them to do so via a phone call or e-mail.
When taking down names of other referrals, always write all of the names first, and then go back and take down
Ask the prospect to prioritize the prospects for you
Keep the person who gave you referrals in the loop
When you get a referral contact them as soon as possible.
People buy because they either need or want something. If we can give someone a reason for buying (satisfying ne
Never lead with a product, lead with need
Don’t waste people time telling them what a product is, tell them what it can do and why it will do it for them
Making the Lights Go On – Need Analysis:
Discover where an imbalance already exists and point it out in a convenient manner.
Training for Need Awareness
Product Knowledge – You can’t be enthusiastic about something you are unfamiliar with. Constantly study your p
Industry knowledge – Where is your industry going, what are the trends? Every industry has several trade publica
what is going on.
Pricing Knowledge – This includes maximizing profits in difficult markets, proper pricing for the market, adapting
negotiating prices. Focus on showing prospects how and why the price of our product of service is fair to them.
Application Knowledge – Know the various instances how your product can and is being used.
Competition Knowledge – Know who you compete with and their strengths and weaknesses

Needs Solution:
Everything you talk about with prospects should translate to customer benefits.
Personalize benefits for the prospect. Paint the picture for them so they can see it.
Clearly articulate the features, functions and benefits of your product.

Do:
Identify a prospect’s emotional values - Find out what your prospect values and how to emphasize that your produ
Consider how it will make others feel - Before a prospect buys, they consider how their manager, colleagues, and c
sales approach accordingly.
Don't:
Focus on price and quality - These aren’t reasons to buy, so don’t use them as such when making a sale.

Investing time in the right place - prospecting - like OP in RK hall - multiple power centers, your connects , influ
groupthink - always one decision maker. “A prospect is an individual or a group capable of making the decision on t
”
criticism is futile

ou ought to be using it

omorrow you'll have the buyer's remorse and a canceled order.

ng wants), the chances are dramatically improved that they will do so.
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MARKETING
Brand names are not guarantees. But they do reduce the range of uncertainty. Since brand names are a substitute
depends on how much knowledge you already have about the particular product or service. Someone who is very k
to get a bargain on an off-brand camera or lens, or even a second-hand camera or lens. But the same person might
of new stereo equipment, if his knowledge in that field falls far short of his expertise in photography.

Owning a piece of consumers mind - which means you don’t have to change the product very often
80% of advertising is about creating pavlovian associations
The bottom line is that brands can create durable competitive advantages, but the popularity of the brand matters
consumers' behavior. If consumers will pay more for a product - or purchase it with regularity - solely because of th
But there are plenty of wellknown brands attached to products and companies that struggle to earn positive econo
returns.

Popular brands aren't always profitable brands. If a brand doesn't entice consumers to pay more, it may not create
Product brand continumm - is it a product or a brand
Cost of creating value < price < perceived value

A firm must have a strong enough customer orientation to recognize changes in customer needs and interests and
appropriate manner. This capability should lead to generating a flow of new products that more than offset lines m
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INDUSTRY ANALYSIS

We are not fit to lead an army on the march unless we are familiar with the face of the country—its mountains and
So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the prim
the moat widened every year.
That doesn't necessarily mean the profit will be more this year than it was last year because it won't be sometimes
very well.
The company with the moat is worth more today because it will generate economic profits for a longer stretch of ti
buying a stream of cash flows that is protected from competition for many years. It's like paying more for a car that
out in a few years.
Strategy explains how an organization, faced with competition, will achieve superior performance

Essence of strategy is choosing what not to do. One upmanship is not strategy. Strategic competition means choosi
unlike warfare in that one company’s success does not require its rivals to fail. It is unlike competition in sports bec
analogy than war or sports might be the performing arts. There can be many good singers or actors—each outstand
audience. The more good performers there are, the more audiences grow and the arts flourish. This kind of value c

Competing to be the best feeds on imitation. Competing to be unique thrives on innovation.

If the rivals all pursue the one best way to compete, they will find themselves on a collision course - competitive co
suffered from this sort of competition for decades, in many categories of consumer electronics, and in personal com

When all else fails and pressure on prices has destroyed an industry’s profitability, often the remedy is to limi
other up, thus reducing the number of rivals and allowing one or a few companies to dominate the market.

When all rivals compete on the same dimension, no one gains a competitive advantage. Head-to-head competition
serve them.

Customers may benefit from lower prices as rivals imitate and match each other’s offerings, but they may also
a standard offering, the “average” customer may fare well. But remember that averages are made up of some
individuals in both groups who will not be well served by the average.

The needs of some customers may be overserved by what the industry offers. In plain English, you will pay mo
about my word processing software. It is also true of most of the appliances in my kitchen. These products ha
and I am both a professional writer and an accomplished cook. As they have become more complex, they hav
customers may be underserved. Think about the last flight you took. It probably met the basic need of getting
Are you eager to fly again?

Competition to be best versus competition to be unique (operational effectiveness versus competitive advantage).
“the best.” The best hotel for one customer is not the best for another. The best sales encounter for one customer
best way to promote environmental sustainability.
In war, there can be only one winner. Victory requires that the enemy be crippled or destroyed. In business, howev
focuses more on meeting customer needs than on demolishing rivals. Just look around. Because there are so many
Industry structure determines profitability - and is sticky (but dynamic) - always analyzed from the perspective of co
Competitive forces - Bargaining power of suppliers, customers, threat of substitutes, new entrants, competition be
Forces range from intense in industries like tires, paper, and steel—where no firm earns spectacular returns—
cosmetics, and toiletries—where high returns are quite common.
In the ocean-going tanker industry the key force is probably the buyers (the major oil companies), whereas in
tough competitors. In the steel industry the key forces are foreign competitors and substitute materials.
Customers, suppliers, substitute products, new entrants are all "competitors" of a company - extended rivalry
Strategy can be defined as building defences against competitive forces or finding a position within an industry whe
Extreme case of competitive intensity is economists's perfectly competitive industry - where entry is easy, existing
rivalry is unbridled because all products and services are alike
Strategy choices aim to shift relative price or relative cost in a company’s favor. Ultimately, of course, it’s the sprea
The goal of competitive strategy is to earn superior results on resources deployed and can be best measured by ret
Value proposition answers three questions - what customers - what needs - what relative prices
Only a value proposition that requires a tailored value chain can be a basis of a robust strategy
Trade offs are choices that make strategy susutainable because they are not easy to match or neutralize
Fit means that value of one activity is affected by the way other activities are perfomed
Good strategies depend on the connection of many things, on making independent choices - fit
Balance of forces is partly due to structural factors are partly within a firms control
One popular management book, Blue Ocean Strategy, uses the metaphor of red oceans versus blue to distinguish b
its authors say, competition is irrelevant.Competition properly understood, is never irrelevant. Most industries exis
The real point of competition is not to beat your rivals. It’s to earn profits
Industry structure determines profitability—not, as many people think, whether the industry is high growth or low,
Structure trumps these other, more intuitive, categories.
The five forces framework explains the industry’s average prices and costs, and therefore the average industry profi
more pressure it will put on prices or costs or both, and therefore the less attractive the industry will be to its incum
Industries can, and often do, create a lot of value for their customers or suppliers while the companies themselves

Managers often mistakenly assume that a high-growth industry will be an attractive one. But growth is no guarante
put suppliers in the driver’s seat, or, combined with low entry barriers, growth might attract new rivals. Growth alo
substitutes. The untested assumption that a fast-growing industry is a “good” industry, Porter warns, often leads to

Typical steps in industry structure analysis:

1. Define the relevant industry by both its product scope and geographic scope.
Product scope. Is motor oil used in cars part of the same industry as motor oil used in trucks and st
marketed through consumer advertising, sold to fragmented customers through powerful channel
packaging. Truck and power generation lubricants face a different industry structure

Although some elements are the same, buyers are radically different in the United States and Mex
need a separate strategy for each market.
 2. Identify the players constituting each of the five forces and, where appropriate, segment them into groups.
3. Assess the underlying drivers of each force
4. Step back and assess the overall industry structure.
5. Analyze recent and likely future changes for each force
6. How can you position yourself in relation to the five forces?
7. Ask key questions:
Why is current industry profitability what it is? What’s propping it up?
What’s changing? How is profitability likely to shift?
What limiting factors must be overcome to capture more of the value you create?
Good strategies are like shelters in a storm. Five forces analysis will give you a weather forecast.

Bargaining power of suppliers (affects cost)

If you have powerful suppliers, they will use their negotiating leverage to charge higher prices or to insist on more f
because suppliers will capture more of the value for themselves. Makers of personal computers (PCs) have long str
case, the Intel Inside campaign effectively branded what might have otherwise become a commodity component
A supplier group is powerful if:
More concentrated than the industry
There are no substitute products
Industry is not an important customer of supplier group
Suppliers product is an important input to buyers business
Suppliers product is differentiated or it has built up switching cost
Credible threat of forward integration
Employees and Labour are also a supplier group. The bargaining power of strong labor unions has been a perennial
The key additions in assessing the power of labor are its degree of organization, and whether the supply of sca
organized or the supply of scarce labor is constrained from growing, the power of labor can be high.

Bargaining power of customers (affects price)

If you have powerful buyers (that is, customers), they will use their clout to force prices down. They may also dema
case, industry profitability will be lower because customers will capture more of the value for themselves

Consider the cement industry. In the United States, big, powerful construction companies account for a large perce
bargain for low prices, thus dampening the profit potential for the industry. Now let’s cross the border to Mexico, w
small, individual customers. Thousands of these “ants,” as they are called, are served by a handful of large produce
returns in Mexico, and not because it creates more value in its home market. In effect, CEMEX is competing in two

When you assess buyer power, the channels through which products are delivered can be as important as the end
purchase decisions of the end-user customers. Investment advisors, for example, have enormous power, and the h
powerful retailers like Home Depot and Lowe’s has put enormous pressure on the makers of home improvement p
Within an industry there may be segments of buyers with more or less negotiating power, and with greater or lesse
negotiating leverage if they are price sensitive. Both industrial customers and consumers tend to be more price sen
relative to their other costs or income ,Inconsequential to their own performance
A movie camera, for example, is a highly differentiated piece of equipment. Its price is small relative to the other co
impact on the success of the movie. Here quality trumps price.
It is high when buyers are:
Concentrated and purchases large volumes from the sellers
Product it purchases represent significant fraction of buyers cost of purchases
Product it purchases is undifferentiated with low switching cost
Earning low profits
Suppliers to Chrysler, for example, are complaining that they are being pressured for superior terms.
Can intergrate backwards

GM and Ford, they engage in the practice of tapered integration, that is, producing some of their needs for
suppliers. Not only is their threat of further integration particularly credible, but also partial manufacture in
aid in negotiation. Buyer power can be partially neutralized when firms in the industry offer a threat of forw

Indifferent regarding the quality of input on the final output of their product
Oil-field equipment, where a malfunction can lead to large losses (witness the enormous cost of the recent
preventor in a Mexican offshore oil well), and enclosures for electronic medical and test instruments, wher
impression about the quality of the equipment inside.
Have full knowledge of product
Retailers can gain significant bargaining power over manufacturers when they can influence consumers' pu
appliances, sporting goods, and other products. Wholesalers can gain bargaining power, similarly, if they ca
which they sell.

Threar of substitues (affects price)

Substitutes—products or services that meet the same basic need as the industry’s product in a different way—put
Sugar producers confronted with the large-scale commercialization of high fructose corn syrup, a sugar substitute,
and rayon who faced extreme competition from alternative, lower-cost materials for many of their respective appli
In 1978 the producers of fiberglass insulation enjoyed unprecedented demand as a result of high energy costs and
tempered by the plethora of insulation substitutes, including cellulose, rock wool, and styrofoam. These substitutes
the current round of plant additions has boosted capacity enough to meet demand (and then some).
Tax preparation software, for example, is a substitute for a professional tax preparer such as H&R Block.
OPEC, the Organization of the Petroleum Exporting Countries, has fended off substitutes by carefully managing the
Switching costs play a significant role in substitution. Substitutes gain ground when buyers face low switching costs
with moving from a branded drug to a generic one. Given that coffee drinking is such a deeply ingrained habit, it’s n
young.

Coinstar’s Redbox—the kiosk that dispenses movie rentals for just $1—has become a tangible threat to Hollywood’
Redbox is a substitute for buying videos, and it is a direct rival to local video rental stores that can’t match the conv

Substitute products that deserve the most attention are those that (1) are subject to trends improving their price-p
produced by industries earning high profits.
In the security guard industry, for example, electronic alarm systems represent a potent substitute. Moreover, they
services face inevitable cost escalation, whereas electronic systems are highly likely to improve in performance and
firms is probably to offer packages of guards and electronic systems, based on a redefinition of the security guard a
systems across the board.

Threat of new entrants (affects price)

Entry barriers protect an industry from newcomers who would add new capacity.
Companies entering an industry through acqusition often have the resources to shake up an industry- should be co
There are seven major barriers to entry - economies of scale, product differentation, capital requirements, switchin
1) Economies of scale:
Scale economies in production, research, marketing and service are key barriers to entry in the mainframe
In manufacturing of TV sets the scale economies are in color tube production and not in cabinetmaking and
For example, scale economies in production, research, marketing, and service are probably the key barriers
General Electric sadly discovered.
Multibusiness company may produce small electric motors which may be used in producing industrial fans,
Potentially shareable activities which give economies of scale can be - sales force, distribution, purchasing a
Joint costs - firm producing product A must have the potential to produce product B- Air freight and Air pas
This same sort of effect occurs in businesses that involve manufacturing processes involving by-products. T
revenue from the by-products can face a disadvantage if incumbent firms do.
Situations in which business units can share intangible assets and economies of scale from vertical integrati
In industry after industry, Porter notes that economies of scale are exhausted at a relatively small share of
General Motors was the world’s largest car company for a period of decades, a fact that didn’t preven
all, it might be more accurate to say that GM was too big to succeed. Meanwhile, BMW, small by indu
decade (2000–2009), its average return on invested capital was 50 percent higher than the industry a

Companies only have to be “big enough,” which rarely means they have to dominate. Often “big enou
influence of winner-takes-all thinking tend to pursue illusory scale advantages. In doing so, they are li
volume, by overextending themselves to serve all market segments, and by pursuing overpriced merg
decades has exhibited all of the above tendencies, to disastrous effect.
The winner-takes-all model presupposes incorrectly that there is one scale curve in an industry and th
that all rivals are competing to offer the universally best product or service. In practice, most industrie
needs.
2) Product Diffferentation
Forces entrants to spend lavishly to overcome existing customer loyalties
The most important barrier in baby care products, OTC drugs, cosmetics, investment banking and accountin
In the brewing industry, product differentiation is coupled with economies of scale in production, marketin
3) Capital requirements
If capital is required for risky and unrecoverable upfront activities like advertising and R&D
Capital may also be required for customer credit, inventories or covering start up losses
Xerox created barriers to entry when it started renting copier machines creating severe working capital req
 The huge capital requirements in fields like computers and mineral extraction limit the pool of likely entran
represents a risky use of that capital which should be reflected in risk premiums charged the prospective en
4) Switching costs
Switching costs may include employee retraining costs, cost of new ancillary equipment, cost and time in te
of reliance on seller engineering aid, product redesign, or even psychic costs of severing a relationship

For example, in intravenous (IV) solutions and kits for use in hospitals, procedures for attaching solutions to
hanging the IV bottles are not compatible. Here switching encounters great resistance from nurses respons
in hardware.
5) Distribution channels
The new firm must persuade the channels to accept its product through price breaks, cooperative advertisi
Sometimes this barrier to entry is so high that to surmount it a new firm must create an entirely new distrib
6) Cost advantages independent of scale
Technology, raw material access, locations, government subsisidies, learning curve
Frasch sulphur firms like Texas Gulf Sulphur gained control of some very favorable large salt dome sulphur
of their value as a result of the Frasch mining technology. Discoverers of sulphur deposits were often disap
value them highly.
Experience can lower costs in marketing, distribution, and other areas as well as in production or operation
examined for the effects of experience.
Cost declines with experience seem to be the most significant in businesses involving a high labor content p
and/or complex assembly operations (aircraft manufacture, shipbuilding).
Texas Instruments, Black and Decker, Emerson Electric, and others have built successful strategies based on
cumulative volume early in the development of industries, often by pricing in anticipation of future cost de
Economies of scale are dependent on volume per period, and not on cumulative volume, and are very diffe
together and can be hard to separate.
Goverment policy can also create barriers to entry
Expiration of Polaroid's basic patents on instant photography, for instance, greatly reduced its absolute cost entry b
Kodak plunged into the market. Product differentiation in the magazine printing industry has all but disappeared, re
scale increased with post-World War II automation and vertical integration, virtually stopping successful new entry

The actions of many U. S. wine producers in the 1960s to step up introductions of new products, raise advertising le
barriers by raising economies of scale in the industry and making access to distribution channels more difficult. Sim
vertically integrate into parts manufacture in order to lower costs have greatly increased the economies of scale th

Some firms may possess resources or skills which allow them to overcome entry barrier into an industry more chea
developed distribution channels for razors and blades, faced lower costs of entry into disposable lighters than did m
opportunities for low-cost entry

Competition between existing players (affects price and cost)

Rivalry among existing competitors takes the familiar form of jockeying for position—using tactics like price compe
customer service or warranties.
If rivalry is intense, companies compete away the value they create, passing it on to buyers in lower prices or dissip
In most industries, competitive moves by one firm have noticeable effects on its competitors and thus may incite re
dependent.
Price competition can make the whole industry worse, in contrast advertising competition can make the whole indu
When firms are numerous making independent moves is more feasible, when it is concentrated the leader can imp
In many industries foreign competitors, either exporting into the industry or participating directly through foreign i
Market share competition is inherently more volatile instead of when there is rapid industry growth
High fixed or storage costs creates pressure to lower costs
Many basic materials like paper and aluminum suffer from this problem, for example
A situation related to high fixed costs is one in which the product, once produced, is very difficult or costly to
This sort of pressure keeps profits low in industries like lobster fishing and the manufacture of certain ha
Lack of product differentiation and switching costs creates pressure to lower prices
When capacity is added in large increments it can lower the profitability of entire industry
The industry may face recurring periods of overcapacity and price cutting, like those that afflict the manufactu
Diverse competitors may create situations when the companies run into each other - each may have a different ide
High exit barriers can mean that companies will keep on competiting even if ROIC is low - specialized assets, fixed c
In the booming recreational vehicle industry of the early 1970s nearly every producer did well, but slow growth sin
competitors, not to mention forcing many of the weaker companies out. The same story has been played out in ind
equipment are just a few examples.

Competitive advantage
Taking offensive or defensive action to minimize the five forces
Innovations in marketing can increase product differentiation
Capital investments in large scale projects or vertical integration can create entry barriers
Three generic strategies : cost leadership, differentiation, focus (niche)
A low-cost position protects the firm against all five competitive forces because bargaining can only continue to
eliminated, and because the less efficient competitors will suffer first in the face of competitive pressures.

Approaches to differentiating can take many forms: design or brand image (Fieldcrest in top of the lin towels and
Macintosh in stereo components; Coleman in camping equipment), features (Jenn-Air in electric ranges); custom
(Caterpillar Tractor in construction equipment), or other dimensions.
Differentiation provides insulation against competitive rivalry because of brand loyalty by customers and resultin
the need for a low-cost position. The resulting customer loyalty and the need for a competitor to overcome uniq
with which to deal with supplier power, and it clearly mitigates buyer power, since buyers lack comparable alter
has differentiated itself to achieve customer loyalty should be better positioned vis-à-vis substitutes than its com

Focus means you have a low cost position with your target customer or differentiation or both (Mungers niche in
Stuck in the middle firm loses profitability
Competitor Analysis - Soul, Skeleton, Skin analysis of the comeptitor
Competitive advantage is about how your value chain will be different and your P&L better than the industry avera
Five tests of strategy
 unique value proposition a company offers its customers - what customers - what needs - what relative
is different from your rivals. If you are trying to serve the same customers and meet the same needs and
don’t have a strategy
value proposition will translate into a meaningful strategy only if the best set of activities to deliver it is d
advantage lies in the activities, in choosing to perform activities differently or to perform different activi
a successful strategy will attract imitators, choices that are difficult to copy are essential.
Trade-offs are the economic linchpins of strategy for two reasons. First, they are an important sour
make it difficult for rivals to copy what you do without compromising their own strategies.
Good strategies depend on the connection among many things, on making interdependent choices. A co
core activities and to outsource the rest. Fit challenges that bit of conventional wisdom.
Companies can change too much, and in the wrong ways. It takes time to develop real competitive adva
trade-offs, and fit. If you grasp the role of continuity in strategy, it will change your thinking about chang
If you have a real competitive advantage, it means that compared with rivals, you operate at a lower cost, comman
The financial measure that best captures this idea is return on invested capital (ROIC)

Market share says we just want to be big; we don’t care if we make money doing it. That’s what misled much
to get an additional 5 percent of the market, some companies increased their costs by 25 percent. That’s reall

In gauging competitive advantage, then, returns must be measured relative to other companies within the sam
similar configuration of the five forces.

A company can sustain a premium price only if it offers something that is both unique and valuable to its customers
prices. Ditto for the high-speed Madrid-to-Barcelona train and the trucks Paccar creates for owner-operators. Creat
to pay (WTP), the mechanism that makes it possible for a company to charge a higher price relative to rival offering

A consumer’s WTP is more likely to have an emotional or intangible dimension, whether it is the trust engend
the latest electronic gadget. Automakers are betting that consumers will pay a price premium for hybrid cars t
Clearly, noneconomic factors are at work in this calculation
Differentiation refers to the ability to charge a higher relative price.
The second component of superior profitability is relative cost—that is, you manage somehow to produce at lower
ways to create, produce, deliver, sell, and support your product or service.
Strategy choices aim to shift relative price or relative cost in a company’s favor.
The sequence of activities your company performs to design, produce, sell, deliver, and support its products is calle
1. Start by laying out the industry value chain.
R&D - Supply Chain - Operations - Sales & Marketing - After sales service
How far upstream or downstream do the industry’s activities extend? 
What are the key value-creating activities at each step in the chain?
 Compare the value chains of rivals in an industry to understand differences in prices and costs
2. Next, compare your value chain to the industry’s.
3. Zero in on price drivers, those activities that have a high current or potential impact on differentiation.
4. Zero in on cost drivers, paying special attention to activities that represent a large or growing percentage
You begin to see each activity not just as a cost, but as a step that has to add some increment of value to the finishe
Difference in relative price or relative costs that arises because of differences in the activities being performed
Betting that you can achieve competitive advantage—a sustainable difference in price or cost—by performing the s
has been better at OE (operational effectiveness) competition than the Japanese, but, as Porter’s work documents
chronically poor profitability.
ent of scale, network effects
s, government restrictions
rger value system.
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FROM INTELLIGENT INVESTOR
A preliminary list of stocks that sold at a multiple of nine or less
Current assets at least 1.5 times current liabilities
Debt not more than 110% of net current assets (for industrial companies).
Earnings stability: No deficit in the last five years
Dividend record: Some current dividend
Price: Less than 120% net tangible assets
Earnings growth: Last year’s earnings more than those five years ago

By Damodaran
1. Earnings-to-price ratio that is double the AAA bond yield.
2. P/E of the stock has to be less than 40 percent of the average P/E for all stocks over the past five years.
3. Dividend yield more than two-thirds of the AAA corporate bond yield.
4. Price less than two-thirds of tangible book value.
5. Price less than two-thirds of net current asset value (NCAV), where net current asset value is defined as liquid current assets
6. Debt-equity ratio (book value) has to be less than 1.
7. Current assets more than twice current liabilities.
8. Debt less twice net current assets.
9. Historical growth in earnings per share (EPS) over the past 10 years more than 7 percent
10. No more than two years of declining earnings over the previous 10 years.
s including cash minus current liabilities.