In this post, I’m focusing on the cash flow statement. If the income statement shows how much a company says it earned, and the balance sheet shows what it owns and owes, the cash flow statement shows what actually moves.

It answers a simple question: Is this business actually generating cash?

Or is it just good at telling a story?

This ended up being one of the most important statements for me, because it cuts through a lot of accounting noise and shows how real the business actually is.

5 Things That I Look For In a Cash Flow Statement

When I read a cash flow statement, I don’t try to analyze everything.

I focus on five signals that help me quickly understand whether the business is actually healthy.

Cash Flow From Operating Activity

This is the most important section of the cash flow statement.

It tells you whether the business actually generates cash from its core operations.

A business can show strong net income, but if it can’t turn that into real cash, that’s a problem.

What I look for is simple:

Is operating cash flow growing over time?

Cash flow from operations starts with net income, then adjusts for non-cash items like depreciation and changes in working capital. We add back depreciation and amortization because the actual cost of depreciation has already been paid when the company purchased the equipment. We add back depreciation and amortization because they are non-cash expenses. The actual cash outflow happened earlier when the company made the investment (capex).

The key idea is this:

If the business is healthy, cash flow from operations should trend upward over time.

For example, Microsoft’s operating cash flow has grown from ~$89B in 2022 to ~$136B in 2025, which is a strong signal that the business is not only profitable, but also highly cash generative.

Capital Expenditure (Capex)

Capex represents money the company spends on long-term assets like data centers, equipment, or infrastructure.

It usually shows up as a negative number because cash is flowing out of the business.

A common mistake is thinking that high capex is always bad.

It’s not.

The real question is:

Is this spending generating future returns?

One tip I have is to compare the percentage of capital expenditure for that year with the company’s annual net earnings.

For mature businesses, I generally prefer capex to be meaningfully lower than earnings. A company with a durable competitive advantage will not spend more capital expenditure than its annual net earnings. If that is so, it indicates that the company requires constant spending in order to keep the business afloat, and it may not be a good business, as you are spending more than you earn. Thus, you’ll see that the company will keep issuing more stock to dilute its investor shares or incur more debt. But context matters.

A good rule of thumb is to have capital expenditures less than 50% of the net annual income of the business. For example, Microsoft’s capex increased significantly in recent years due to AI infrastructure and data centers. If you look at Microsoft, the pre-AI capex to annual income ratio was 20 - 30%. However, in 2025 and beyond, its capex spending has quadrupled due to data center expansion and AI compute. The capital expenditure to annual earnings ratio grew from 30% to 60%.

On the surface, that looks concerning.

But if that investment leads to stronger long-term returns and reinforces its moat, then it’s actually a positive.

There’s a big difference between:

• spending to grow

• spending just to survive

Does the company practice Share Buybacks

Share buyback will be treated as a negative value in the cash flow statement because the money is flowing out of the business by buying its own shares. Although it is a negative, investors see it as a positive thing. Why? because it increases return to shareholder equity by making each share worth a lot more. Thus, increasing the wealth of the shareholder.

This is very similar to a company that pays a dividend, which gives money back to its investors, except with share buybacks, the shareholder doesn’t have to pay any taxes until they sell.

The best indicator is to see if a company has historical data that it is buying its own shares or retiring them. This often means the company is generating more cash than it can reinvest at high returns, so it returns capital to shareholders. Thus, giving back to the investor to make them richer.

Stock-Based Compensation (SBC)

This is something investors care a lot about.

Why?

Because it dilutes shareholders.

Even if the company is growing, issuing too much stock means your ownership percentage is shrinking. Typically, startups allocate more stock-based compensation to employees due to the need to offer higher premiums for growth and limited cash resources. As the company matures and shifts focus toward shareholder investment returns, the stock-based compensation ratio relative to net income will tend to decline.

I like to look at SBC relative to net income:

• < 5% → great

• 5–15% → normal

• 15–30% → something to watch

• > 30% → concerning

For Microsoft, SBC is around $11–13B vs ~$70–100B in net income (~12%), which is reasonable.

Some level of SBC is normal, especially in tech.

But consistently high SBC can indicate that the company is relying too much on equity instead of cash. In 2024, renowned investor Chris Hohn sent a letter to Google addressing the excessive stock-based pay given to its employees. He pointed out that Google employees’ compensation was 67% higher than Microsoft’s. Hohn recommended either limiting stock-based compensation to non-engineering staff or cutting overall staff by 20% to revert to 2021 compensation levels.

Debt (Borrowing vs Repayment)

This section tells you how the company is using debt over time.

A healthy signal:

The company is gradually paying down debt or keeping it stable while growing cash flow from the operating activity.

A red flag:

Debt is increasing faster than operating cash flow, without a clear return.

For example, Intel’s recent earnings revealed a significant debt issuance and weakening cash flow from operating activities. This indicates that the business needs more attention as capital intensity increases. However, if earnings do not recover, it signals a potentially dangerous situation.

Another red flag:

The company keeps refinancing and issuing new debt to pay off old debt.

This can create the illusion of stability while the actual debt burden doesn’t improve.

For example, if you look at AT&T, you’ll often see large debt issuance and repayment happening at the same time, with total debt staying high. Looking specifically at the cash flow from financing activities, the net long-term debt issuance and repayment are similar in size and occur regularly. Additionally, the long-term debt level remains constant. This suggests that AT&T might be using new debt to pay off old debt, maintaining this cycle.

That tells you the company may be rolling its debt forward rather than reducing it.

For Microsoft, the story is different:

It has been consistently paying down debt and only issuing selectively, which reflects strong financial discipline.

Questions

What do you usually look for when reading a cash flow statement?

Is there a signal you rely on that I didn’t cover?

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In this post, I want to continue the exercise by looking at the balance sheet, using Microsoft as the main example, while also referencing a few other companies along the way.

If the income statement tells you how much money a company made, the balance sheet tells you what the company actually owns and owes at a given point in time.

Think of it like a snapshot of a company’s net worth.

Just like evaluating your own personal finances, the balance sheet helps answer questions like:

• How much cash does the company have?

• How much debt does it owe?

• Is it accumulating wealth over time?

When I read a balance sheet, I’m not trying to memorize every number. Instead, I focus on a few key signals that tell me whether a business is financially strong and whether it might have a durable competitive advantage.

In this post, I’ll walk through five things I look for in the balance sheet, using Microsoft as a real example.

How the Balance Sheet is Structured

The balance sheet is organized into three different sections: Assets, Liabilities, and Shareholder equity.

The order of items within each section also follows a logical structure.

Asset

Within the Asset section, the order comes from the most liquid asset, such as cash, to the least liquid, such as a long-term investment in a company.

Liabilities

For liabilities, the order comes from the fastest that requires to be paid off to the longest time required to be paid off (long-term debt).

Shareholder Equity

For shareholder equity, we will start with common/preferred stock value, retained earnings, and then treasury stock.

Now, to get a full picture of the net worth of the company, sometimes I need to look back at a couple of years of balance sheets and compare them. The important point here is consistency. If there are any anomalies within the balance sheet, I will need to understand why there are such anomalies.

Just like you evaluating your own networth, the higher the better. That means the company is rich, and they are able to provide more value to its shareholder.

Here are 5 items in the balance sheet that I look at to see the overall health of the company and to see if it has a moat:

Cash

A strong business typically generates cash from its operations, not from selling assets or issuing debt.

When I analyze cash on the balance sheet, I try to understand where that cash came from and whether the company can continue generating it consistently.

There are 3 ways to generate cash:

• Sell bonds

• Sell its asset

• Generate profit through operations

The last one will be the most desirable. It indicates that the company has a competitive advantage, meaning it can generate significant cash.

Another thing to consider when evaluating a business is whether a large stockpile of cash is necessary to weather the storm. In some industries, large cash reserves are necessary to survive downturns, especially in cyclical or capital-intensive industries like airlines or banking, which indicate that it has a thin margin.

Lastly, if you are comparing two companies of the same cash, but different liabilities, the company that has the lowest liability is a stronger business than the one with higher liabilities.

Berkshire Hathaway generates a large pile of cash from its operating business, BNSF Railway, Geico, and Berkshire Hathaway Energy. And Warren Buffett insists on keeping a massive cash buffer to weather the financial crisis. Thus, it is able to use cash to invest in a distressed company and invest in a better company during a crisis.

Microsoft’s Cash & Cash Equivalent has been decreasing because it puts a lot of uses on its Capex for data center investment.

Goodwill

When a company acquires another company for a price higher than its value, the difference between the value price and the purchase price will be part of the goodwill. For example, if Disney acquired a company for 4 billion, but the identifiable asset is only worth 2 billion, then the remaining 2 billion will appear in the balance sheet as goodwill.

If a company’s goodwill keeps increasing, that means that the company is out there buying other companies. At a premium price, more than that is worth acquiring. Thus, it can be a good or bad thing. But you can’t really see them from mainly looking at Goodwill. You have to look more into the brand value, patent, distribution, and other intangible assets that the company is acquiring, and check and see if it aligns with its core thesis. To view this quantitatively, you can check if the Earnings per share (EPS) and free cash flow have grown ever since the acquisition, and this helps tell the investor that the acquisition is helping the moat of the company rather than just overpaying.

Back to the example, for a media company such as Disney that acquired Marvel, it shows 2 billion as goodwill. We can see that the additional 2 billion can be the intangible asset, such as its brand and franchise, as intangible assets that are created by the company will not be presented in the balance sheet. Thus, it depends on how the board members of Disney evaluate the intangible assets, such as brand value and intellectual property of Marvel.

And in this scenario, the acquisition was a great move by Disney as it helps increase the competitive advantage of Disney. After Disney bought Marvel, we can see that the Marvel franchises have exploded, and Disney has minted a billion dollars from Marvel’s franchise and merchandise. They had the Marvel’s Avengers movies in theaters, which became one of the highest-grossing movie revenues ever made, generating $20 billion in revenue globally. Disney has incorporated a lot of Marvel’s merchandise into its theme parks.

If a company overpays, you will see the goodwill impairment on the operating expense. This means that the business that you acquire drops in value, and you need to put that in your disclosure in the income statement. The overall carrying goodwill in the balance sheet will decrease. Disney has not written down Pixar and Marvel, but it did write out Fox for 557M in 2025. It signals that their $70 billion Fox acquisition was far above its value price.

However, one thing to watch out for with Goodwill is that its total value is compared to its total assets. If a large portion of the total asset value relies on Goodwill, it generally means that the company is using acquisitions to drive growth instead of organic growth. This indicates that its own business has weak organic demand and that the business model itself may not have a durable competitive advantage because it relies on acquisitions to drive growth.

Short and Long-term debt

Debt is not always bad. What matters is whether the company can comfortably service its debt with earnings and cash flow. However, in general, having debt indicates that the business has a thin margin and will require debt to fund its operation and to grow.

The difference between short-term debt and long-term debt is the length of time it takes to be paid off. For short-term debt, the company has a maximum of 1 year to pay off the debt, while long-term debt is debt that needs to be repaid for more than 1 year.

Short-term debt is worse than long-term debt if the company doesn’t have enough cash flow in the business. One thing to watch out for is a business model that borrows short-term debt to lend money for long-term. Imagine if the customer who borrowed the money couldn’t pay - suddenly, the business cannot repay the short-term debt, and it will cascade to its overall business. One example of this is Bear Stearns, which uses short-term debt to trade or buy assets that will mature over the years. It borrowed 100B of money overnight from the bank and used that money to buy mortgage-backed securities that require 10-30 years to pay off. Thus, they will need to keep borrowing every day to keep the fund running. So it made money by rate arbitrage - if you borrow for 3% interest rate, and you lend the money that you have for 5%, you are effectively earning 2% as a profit. This eventually caused the 2008 financial crisis, where the mortgage securities started to lose their value, and the lender started to worry about Bear Stearn’s balance sheet. Then, the lender of Bear Stearns stopped lending because it was afraid that it couldn’t be paid off. And the entire company instantly collapses.

For long-term debt, I usually look at the time series data of how the company is holding its long-term debt. If it holds little long-term debt compared to its net earnings, it means the company has enough cash to pay them off and also has some sort of moat. What is a good caliber to evaluate the threshold of a “good” long-term debt? Good businesses typically are able to pay off their entire long-term debt based on their 3-4 years of net earnings.

Retained Earnings

Retained earnings are a part of the money that is logged in the balance sheet after dividend payout, and stock buybacks from its net earnings. Those are like the take-home money, where they are putting the rest of the money in the company’s checking account, ready to be deployed or saved. Retained earnings are accumulative, which means the number that you see in the retained earnings is the total retained earnings that the company has, not the money that the company will be putting into the retained earnings. For example, Microsoft’s retained earnings have grown year over year and have reached hundreds of billions of dollars today

I look for a company that has an increase in retained earnings year over year. That means the company has enough money in its bank account to use it for company growth, or for research and development to increase its moat. If the company is not profitable, its retained earnings for that year will decrease because it needs to use its checking account to pay down any liabilities.

Another thing to check out is whether management creates value with retained earnings. For every $1 of retained earnings, does it produce more than $1 dollars? We can look at retained earnings growth relative to EPS; if both are growing at the same time, it is a good sign. However, if EPS is stagnant, that means management is not wasting its retained earnings.

This is what Warren did with Berkshire Hathaway - he decided to retained 100% of its earnings and use that money to acquire companies that generate more moat for Berkshire Hathaway. Warren Buffett and Charlie Munger didn’t issue a dividend or stock buybacks. It uses the retained earnings to buy Sees Candy in 1972, BNSF Railway in 2009, and Apple stock in 2016. Those investments ended up generating more returns, back to the retained earnings.

Thus, look for retained earnings that are positive, because it means that the company has generated a good amount of value since its founding. However, a dip in retained earnings may mean a couple of things:

1. They are losing money and are required to pay down their liability

2. They are using that money for buybacks and acquisitions

The first option is bad. The second depends. If it is buybacks, it can be good if the stock value is lower than its valuation and management uses this opportunity to buy back stocks. However, if the stock value is high and management uses the retained earnings to buy back stocks for its shareholders, it is not the best because they are essentially paying a premium to buy the stocks.

Treasury Stock

Treasury stock shows that the company has repurchased shares, which can increase shareholder value if done at the right price. Usually, the value will be negative.

The source of the share buy-backs is also important, as it helps to check if the company uses its free cash flow to conduct share buy-backs instead of accumulating debt for share buy-backs. For 10Q in Microsoft, you can see that the treasury stock is listed as “Accumulated other comprehensive loss”.

However, the company can also keep doing share buybacks to bump up its stock price. Thus, in order to understand the total return of shareholder equity, we need to add back the treasury stock with the rest of the shareholder value, and divide the net earnings by the value to discount the financial engineer in place from the stock. A high return on equity is a strong signal of a good business. As a rough guideline:

• An average business will have a 10-12% return on shareholder equity

• A strong business will have a 15 - 20% return on shareholder equity

• An exceptional business will have a greater than 25% return on shareholder equity

Microsoft's total shareholder equity is 31%, which is exceptional.

Takeway

A balance sheet is a snapshot of a company’s net worth. When I read it, I focus on a couple of key signals:

• Cash is the energy source a company requires to keep operating its business. Don’t only look at the accumulation of cash, but also understand how it accumulates the cash.

• Goodwill indicates how management is thinking of the company’s strategy and its acquisition strategy.

• Debt Levels

• Retained earnings growth

• Share buybacks

None of these metrics should be analyzed in isolation. What matters is not the numbers, but the reasons behind why the numbers exist in the first place and change over time. Then, discovering if such a company is going forward with its long-term mission and is having a competitive advantage depends on how the management is telling these stories.

Questions - What are the key things that you look for when looking at a balance sheet?

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It reported substantial cloud revenue growth, and the result of the financial statement looked strong.

But the stock plummeted 10% after hours.

I started searching around the internet, and I saw wildly different takes. Some people on Twitter mentioned that this dip is necessary to buy, while others were cautious to stay away until it hits $350.

How did they have so much conviction with the stock prices, and if it is a buy, hold, or sell?

It all comes down to knowing the financial health (accounting) of the company with a twist of intuition. Warren Buffett said that it is a language of business, and it is one of the prerequisites to invest in great companies for the long run.

This will be a multi-part series to share my insights on value investing and how to identify exceptional companies with durable competitive advantages. In this first series, I wanted to share with you how I interpret the Income statement, specifically, by trying to understand what’s important to look out for when a company like Microsoft reports its 10-Q. I will be using the 10Q for Q1 2026. This isn’t about predicting Microsoft’s stock price. It’s about learning how to read a 10-Q income statement the way a value investor does - by understanding the fundamentals.

Where to Start?

The first step I’ll take is to read the MD&A to understand the management narrative and the bigger picture. The MD&A explains how each business segment performed that quarter, which makes the rest of the 10-Q easier to navigate and cross-reference.

What to Focus On?

I don’t read them like an essay. I read between the lines of the MD&A, highlight keywords, and compare numbers against the past performance to determine whether anything requires further attention. Track trends not only for this quarter but for previous quarters.

For instance, Microsoft’s operating expenses increased dramatically this quarter, which is unusual. However, if you look at the industry’s general trend and understand that those operational expenses are due to efforts to increase R&D to remain competitive, it is not a major red flag.

In this section, I want to focus on how to look at the income statement. Specifically:

• Revenue

• Profit Margin

• OpEx

• Net Income

• EPS

Let’s explore each item in detail, and understand these items beyond the numbers, and how I analyze them.

Revenue

Revenue is what the company receives at the door (they also call it the topline number) - how much the company is actually getting from all the goods and services sales.

The important thing about the revenue is to understand that not all revenue is the same, and investors prefer revenue that is resilient, which is revenue that is recession-proof.

What this means:

• Recurring revenue is valued highly over one-time payment revenue.

• Stable revenue is preferable to cyclical revenue, which varies greatly - high during good times and drops during bad times. For example, Peloton’s revenue surged during the pandemic but plummeted afterward when people stopped staying at home.

• Revenue with a higher gross profit margin is better than revenue with a lower gross profit margin.

• Revenue that becomes cash is of a much higher quality than revenue that returns as accounts receivable.

For example, I can see that the Reportable Segments used to divide Microsoft’s revenue in the 10Q are: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Then it further explains each segment and provides a summary of the operations on page 33 of Part 1, Item 2.

As you can see, Microsoft groups Productivity and Business Processes and Intelligent Cloud into a single bucket. The important thing to note here is to check each revenue stream against how it defines the success metric.

One example is Microsoft 365 Commercial cloud revenue growth; it notes that revenue from Microsoft 365 Commercial subscriptions, which includes all Microsoft 365 Ads, cloud, security, and enterprise offerings. This revenue is:

• Recurring

• Converts to cash directly

• Sticky: it’s not cyclical, where if there is a recession, the company will abandon Microsoft 365, as its data and resources are already accustomed to the system and employee productivity.

Revenue shows how a company makes money, but not how durable that company is. Gross margin gives you the first real signal of competitive advantage.

Gross Margin

Gross margin is how much a company makes when revenue minus all the costs of goods sold. For example, if Microsoft offers a subscription product for $ 2000 annually, the direct costs associated with producing that service- such as employee labor, customer support, and server costs directly linked to that service- are considered part of the cost of revenue.

If you can have a higher gross margin on your product, that means either:

1. You have a durable, competitive edge over your competitor

2. You are in a market where there isn’t much competition. Thus, you are able to charge a high premium to your customer and have a high profit margin

I look for trends to see whether the gross margin increases over time, and if so, which part of the business is driving the change.

As a rough rule of thumb, a gross margin of over 40% indicates that the business has a competitive edge. A gross margin that is 20-40% in a fairly competitive market, and a gross margin below 20% indicates that the business is operating in a very competitive market, where neither the business nor its competitors has a competitive advantage over the long run.

In the above Microsoft 10-Q case, the gross margin was not shown (instead, it mentioned operating income). However, we can calculate the gross profit margin of each segment by having revenue subtracting the cost of revenue and divide them by revenue:

• Productivity and Business Processes: 82.1%

• Intelligent Cloud: 58.8%

• More Personal Computing: 55.8%

This indicates that Microsoft’s three segments of the business have some competitive advantages in the market over their competitor.

OpEx

OpEx is all the expenses that are not directly correlated to production. This includes rent, utilities, employee, legal, marketing, sales, and admin - everything required to run and grow the business.

Ideally, it is best when we keep OpEx as low as possible. However, it is more nuanced on company to company basis.

As a rough rule of thumb, I like to see OpEx spend be less than the profit Gross Profit Margin, roughly around 30%. If it is over 100%, the company is losing money and will need to investigate further to determine why it requires such a high OpEx level.

From the chart above on the Segment result of operation, we can calculate the percentage of operating expenses in comparison to the gross profit margin and identify if the growth of the business is being bought, or if it contains a perpetual growth loop. For Microsoft, the SG&A relative to gross profit margin on each segment:

1. Productivity & Business Processes: 26% of the gross profit consumed by OpEx

2. Intelligent Cloud: 28% of gross profit consumed by OpEx

3. More Personal Computing: 52% of gross profit consumed by OpEx

I can see that the More Personal Computing section is very competitive and has less operating leverage because the sales and marketing burden is heavily related to profit. The best segment that Microsoft has is the Productivity & Business Processes, where it has strong subscription consumer enterprise-based and higher margins.

The above are the SGA of Microsoft. I’ll look at the percentage of SGA in comparison to the revenue, and this will indicate a couple of things:

1. Microsoft is having operating leverage where it can scale revenue relatively to ensure that the OpEx doesn’t increase as well.

2. Check if the revenue increases faster than the operational expenses. According to this financial statement, it looks like the 2024 opex to revenue ratio decreases from 9% to 8% for Sales and Marketing, and 3% to 2 % from general and administrative. While those specific category increases from 2024 to 2025. This indicates that the revenue growth rate is faster than the opex, and that growth is not bought by marketing spend.

Interest Expenses

Interest expense is the amount of interest payments the company has. If that company has high interest expenses, that means it has a high amount of debt. In addition, I am trying to understand if debt is helping the business, hurting it, or is irrelevant.

A company that has a durable competitive advantage often has low interest expenses.

I would check if the interest expenses and compare them with the operating income. If the value is over 100%, that means that the company may be over-leveraged, and I would be cautious to see if it can pay back its debt. A competitive, durable company usually has less than 15% of its interest expense as a percentage of its operating income.

In addition, I will also make sure that the interest expenses are stable, and they don’t fluctuate like crazy quarter over quarter. This will make the business look more volatile as it is not as predictable due to regulation and economic policy.

Let’s look at Microsoft’s interest expenses.

From the above statement, I can see that:

• The ratio of the interest expenses in 3 months (736M) to operating income (38B) is less than 2%. Microsoft is not financially stressed, and the debt doesn’t impact its revenue or core business, and any kind of interest rate changes will also have no impact on its core business. This indicates the resiliency of the business.

What will make me cautious is if:

• The interest expenses to operating income ratio is increasing

• The interest expenses are volatile every quarter

• Management is talking about rate exposure or financing.

Net Income

Net income is essentially the take-home pay of that company after subtracting all the taxes, operating expenses, and fees.

I typically look at the net income of the past trailing 10 years to see if there is a nice upward trend. If net income spikes one quarter, I treat it as a one-off until proven otherwise.

The ratio of net income to revenue also indicates how the company operates economically compared to its competitors. A higher net income-to-total-revenue ratio usually indicates that the company is more durable. For example, a company that earns 2 billion with a total revenue of 5 billion is better than a company that earns 5 billion in income with a total revenue of 100 billion. A company that has a ratio of 20% and above signals that it has some kind of moat. While a company that is less than 10% reveals that the business and the industry itself are competitive (such as the airline industry).

Microsoft’s net income to total revenue has a ratio of 47% for the quarterly net margin and 42% for the six-month net margin, compared to 2024, which is 34% quarterly and 36% six-month period. It increase 12%, which is significant.

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EPS

Earnings per share are calculated by the net earnings divided by the total number of shares outstanding. All else equal, the higher the earnings per share, the higher the stock prices should be.

If there is an increase in share outstanding year after year, I would be cautious, as this may dilute the value of the shareholder by issuing lots of stock-based compensation or some other form.

I usually look at the 10-year earnings per share and see if it trends consistently upward. If it does, it means a couple of things:

• The company sells products or mixes of products that don’t need to go through an expensive or extensive reinvention or changes. Usually, if a company needs to reinvent and go through an expensive process on its product, the EPS will go crazy during the launch year, then will go down during the transition year, and will plateau during the retooling years.

• The company is doing share buybacks by increasing the value of each share unit.

• The company has a pricing power or some kind of operating leverage that can grow its revenue by either charging its consumer in a higher premium and minimizing the operating expenses.

The important thing to note when looking at earnings per share is how it usually increases. There are only 2 ways:

1. Increase your earnings

2. Decrease the amount of shares outstanding by conducting share buybacks

If the increase in EPS is due to number 1, it is a good sign that the company has some competitive moat. However, if the EPS steady growth is due to reason 2, there are a couple of things that I would read between the lines. First, is the revenue increasing or decreasing year over year? Sometimes, management covers the fact that the business is not compounding, and it uses buy-backs as a vanity metric to show investors that the company is growing. Second, if the management decides to do a buyback at a high valuation, that means management is not leveraging its cash flow effectively - they are using the money to buy their stock very expensively. Third, if the management is optimizing short-term metrics over long-term company growth. If the company manages the money by buying back stock and inflating the stock prices right now instead of using that cash to reinvest and do R&D, it can create more growth in the future.

A couple of things that I would reflect on if buybacks are healthy:

1. Is the buyback used for offsetting stock-based compensation?

2. Are the buybacks funded by the excess cash or by debt?

3. Would the EPS still grow without any buybacks?

If the answer to these three is yes, then the buybacks should be healthy.

For Microsoft, I see that the EPS section, the share outstanding decreases slightly, and this is probably due to offsetting the stock-based compensation. If they are conducting share buybacks, the number of shares outstanding will decrease dramatically. As a result, I think this share buyback is healthy.

Takeaway

As I understood the nuances and strategy, everything started to click. And it all comes from the income statement: revenue, cost of goods sold, profit margin, operating expenses, Interest expenses, net income, and earnings per share.

The most important thing to take away from the income statement is how the company earned during that period, and the most important indicator of a competitive and durable company is consistent, upward earnings over time. In the end, value investing isn’t about predicting prices. It’s about understanding how a business earns - and whether those earnings can compound.

If you read income statements regularly, I’m curious - what’s one metric you used to ignore but now pay close attention to and why?

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