Warren Buffett’s secret sauce
And what we can learn from the collapse of Enron
“Accounting is the language of practical business life. But you have to know enough about it to understand its limitations — because although accounting is the starting place, it’s only a crude approximation. And it’s not very hard to understand its limitations.” — Charlie Munger
Warren Buffett is regarded as the world’s most successful investor. As chairman and CEO of investment conglomerate Berkshire Hathaway Inc, he runs the world’s most valuable financial services company, posting revenues of over $200B in 2017.
In the investing world, Buffett is an outlier. Where hedge funds undertake complex, high-frequency trading strategies, Buffett takes a radically opposite approach.
Berkshire Hathaway’s entire investment philosophy follows the Benjamin Graham school of value investing. That is, understanding the intrinsic value of a company, then buying it at a discount to their market valuation.
“Price is what you pay, value is what you get”
What’s fascinating about Berkshire Hathaway’s philosophy is that investment decisions are made using the same information that is available to the rest of us plebs.
This information, primarily in the form of financial reports and announcements are publicly available and accessible on the internet.
So, if Buffett has access to the same information we do, how does he continue to make sound investments and ‘beat the market’ in financial returns?
What’s the secret sauce to Buffett’s success?
Critics say there are multiple factors. Firstly, Buffett is the master of controlling emotions. He doesn’t get caught up in fads or short-term market fluctuations. He thinks long term and spends a lot of his time thinking and making decisions in his ‘System 2’ part of the brain.
The second and most interesting factor is that Buffett sees a company differently to how we do. The way he interprets a company’s set of financial statements is different to how you or I do. Through this analytical lens, he is able to spot patterns and trends that laymen are blind to.
Understanding how Warren Buffett views company and financial performance leaves clues on how you can build a more valuable and cash-rich business.
And it starts with the numbers.
Accounting Profit is Fake
Yep, you heard me correctly.
Your accountant’s idea of profit is prepared according to tax adjustments and accounting standards. These were established to provide consistency and governance across how accounting is done. The problem is these ‘rules’ are very much open to interpretation — leaving room for ‘creative accounting’.
Dodgy CEOs and CFOs know all the tricks of creative accounting and can easily dupe the market.
The collapse of Enron is an infamous example of how investors and business owners assess a company’s financial performance is guided by all the wrong numbers.
The illusion of ‘profit’ whilst the company was entering bankruptcy fooled thousands of investors into thinking it was a valuable company.
Let’s take a look at a summary of Enron’s financials, leading up to its collapse in 2001.
From a ‘net profit’ perspective, Enron was crushing it. It was profitable year-on-year, growing at 12% compounded growth.
But if you look at the Net Cash Flow position, you will see that the company was losing cash. Not only did it burn through over $3.1B of cash over that 6 year period, it only had two years of positive cash flow!
You would think that would send alarm bells to investors. But it didn’t — because they were too focused on looking at profits and the share price, not cash!
You can fake profit, but you can’t fake cash.
Warren Buffett’s secret sauce
Warren Buffett isn’t fooled by companies like Enron. He knows all the evil tricks adopted by companies to manipulate financial statements and the flaws in accounting in general.
He’s able to cut through the wizardry and understand the truth behind a company’s financial performance.
One of Buffett’s secrets is this.
Rather than looking at a company’s ability to generate ‘profit’, which can easily be manipulated, he looks at a company’s ability to generate cash flow.
Buffett pays close attention to a metric called Free Cash Flow.
Free Cash Flow — the Warren Buffett metric
Free Cash Flow is a Frankenstein metric that considers both accounting profit and cash flow. It’s measured and assessed by investment gurus like Buffett because it gives a clearer view of a company’s ability to generate positive cash flow.
A positive Free Cash Flow means your company is actually generating surplus cash flow. Negative Free Cash Flow means your company is burning cash (hence the term Burn rate).
What I love about Free Cash Flow is that it not only gives you an accurate view of your cash flow position, it also provides clues on how to improve it. It can help us understand what changes we can make to unlock more cash.
Calculating Free Cash flow
You can understand your firm’s Free Cash flow. The formula is:
Free Cash flow = Net Profit + Non-cash expenses — Change in Working Capital — CAPEX
There’s couple of things to note here:
- Non-cash expenses is depreciation, amortization and bad debts. Your accountant will typically account for these in your financial statements.
- CAPEX stands for capital expenditure. This is the money sent on capital equipment like your motor vehicles and plant and equipment.
Let’s look at an example.
Although the company made an accounting profit of $1,800,000, it only generated $890,000 of free cash flow. Why?
Well, a total of $940,000 of cash is tied up in working capital. This company can increase it’s cash flow by:
- Reducing accounts receivable days; and
- Improving their inventory cycle so they hold less stock.
One other thing. Notice how there’s a direct correlation to your Free Cash Flow and the movement in working capital? Effective working capital management means better cash flow!
Free Cash flow leaves clues
I recommend that every business measures and monitors Free Cash Flow.
The primary benefit of assessing Free Cash Flow is that it provides clues on how to improve cash flow.
For example, Free Cash Flow considers the ebbs and flows of working capital (the accounts where your cash is hiding). Drilling into these accounts can help you understand how to unlock this cash.
Free Cash Flow is uncommon to measure
It is highly unlikely Free Cash flow is reported in the financial statements prepared by your tax accountant.
Why? Because it’s not legally required. Remember, these financial statements are prepared in accordance with the tax office and other regulatory bodies.
In other words, traditional financial statements are not designed to help entrepreneurs understand their finances.
This is a reason why you need to see them Stark Naked.
