Learning in the Classroom: A Company with a Durable Competitive Advantage
Anisa Barutis was a student of Dr. Koch in his BUS 422 Investments class at NC State University. She will be graduating with a degree in Finance in May 2025. Her LinkedIn profile: https://www.linkedin.com/in/anisa-barutis/
Williams-Sonoma Inc. (WSM)
Competitive Advantage
Competitive advantage as described by Buffett allows companies to either charge more for their product or sell many more of their products. Williams-Sonoma is a household name. When people make their wedding registries, they need kitchenware and Williams-Sonoma’s high end reputation places many of its items on these registries and wish lists. The advantage of having a respected brand and good reputation is that they are able to charge high prices. They also carry very nice brands and a wide variety of kitchen products in their retail locations and online. The combination of these factors makes the company one that will be in business for a long time. “Durable” means consistent, and Williams-Sonoma has been selling kitchenware for the last 68 years.
5-Year Time Series- Revenue, ROE, & EPS
For each of the following, I pulled data from the company’s annual report and made the graphs in Excel.
Revenue on its own does not give a full picture of the firm’s success. This figure is simply the amount of money brought in from the sale of products in a given time period. If a firm is making a lot of money but spending more, then it is operating at a loss. We can tell from this graph of Williams Sonoma’s revenue over the five-year period from 2018-2022 that there has been an increase in revenue each year. This graph is a very similar shape to the EPS graph because there is slow growth from 2018-2019, more dramatic growth from 2019-2021, and slower growth fom 2021-2022. The fact that there is growth each year is a good thing on the surface, but more detailed information from the financial statements will be crucial for forming a decision about the company’s durable competitive advantage.
A high Return on Equity (ROE) is a sign of a company with a strong competitive advantage. The ROE for these five years was calculated by dividing net income by shareholders’ equity in each of the five years. The insight that this provides is that the higher the ROE, the more money the firm is generating per dollar of shareholder equity, and this is a good thing for shareholders. From 2018-2019, there was a very slight decline. From 2019-2021, there was a substantial increase which is like the graphs for revenue and EPS. From 2021-2022, there is another decline in ROE. This decline in the most recent year on the chart is not a good sign of a durable competitive advantage, however, viewing long term trends over more than five years could provide better insight.
Earnings Per Share (EPS) is a tool for measuring a company’s durable competitive advantage. While Buffett recognizes that any single measurement cannot provide a whole picture of a company, this one is important. Generally, the higher EPS, the higher the stock price. Over a ten-year period, it is desirable to have consistent and upward trending EPS. In this five-year period graph, growth is slow between 2018-2019, steadily increasing from 2019-2021, and is leveling out again from 2021-2022. There has been growth every year since 2018 which indicates a competitive advantage of some kind. Consistent earnings indicate that the company has not needed to go through expensive changes and the company is consistently selling its products.
Income Statement
The income statement is the first place Buffett goes to look for a durable competitive advantage. Revenue, expenses, and overall profit or loss are key pieces of information in this statement. Profit alone is not a good indicator of a long term durable competitive advantage. Factors such as margins, leverage, and research and development costs are indicators of a competitive advantage that can be found in or calculated from the income statement figures. Revenue is always the first line on the income statement. It’s the amount of money that comes in the door of the business during the specified period. An important thing to remember is just because money is coming in, this does not guarantee that the company is earning a profit. Williams Sonoma has continued to earn increasing revenue from year to year, but growth slowed from 2021-2022.
The revenue growth rate has increased from year to year, which is a good sign for Williams Sonoma. Steady growth is a sign for a competitive advantage. However, the increases from 2019-2020 and 2020-2021 are substantially higher from the most recently calculated growth rate of only 5.19% from 2021-2022.
Cost of goods sold is the next item on the income statement. Another name for it is the cost of revenue. It cannot tell us much about the competitive advantage, but it is a valuable input for determining gross profit which does help determine a long-term competitive advantage. There is a consistent upward trend for COGS at Williams Sonoma.
Gross profit is revenue less cost of goods sold, and it shows how much money the company made after the raw materials and labor costs are subtracted. Again, it’s not the most useful on its own but it is used for determining gross profit margin. Buffett notes that companies with consistently higher gross profit margins also have good long-term economics. Generally, 40% or higher indicates some kind of durable competitive advantage and below 40% indicates a competitive industry. From 2018 in the upper 30s to 2022 over the 40% threshold, Williams Sonoma seems to have a competitive advantage that is growing. The upward trend is a sign of a good business and competitive advantage.
Buffett describes operating expenses as the “thorn in the side of every business.” These costs can greatly harm the competitive advantage of the firm. They include selling and administrative expenses, research & development costs, and depreciation. Operating expenses are used to calculate operating profit (loss). Along with the other statistics so far, there is an upward trend in operating expenses from year to year.
SGA expenses are all expenses related to selling and administrative activities and they include management salaries, advertising, legal fees, etc. These expenses can have a very large impact on the bottom line. Consistently high SGA expenses are a warning sign, but if a company has consistently low SGA expenses, the bottom line can still be impacted heavily by researc and development costs. For large retailers, SGA expenses of 15-20% of sales is expected.
Research and development costs are a major indicator of a durable competitive advantage. High research and development costs indicate a flaw in the competitive advantage, and they will put long term economics at risk. For example, patents expire and when they do, the competitive advantage disappears. New technologies are also something to be careful of because as soon as something better emerges, the old one is obsolete.
The amount of depreciation recognized in a year counts against income for that year. It is important to include in the calculation of earnings because otherwise, you’re tricking yourself into believing the business is earning more than it actually is. Lower depreciation costs as a percentage of gross profit is an attribute of companies with a durable competitive advantage. Depreciation for Williams Sonoma has consistently been below 8% of gross profit, which is a good sign.
Interest expense is a financial cost and most retailers are paying more interest than they earn. It’s an indicator of how much debt the company is holding. Companies with a durable competitive advantage often have very low interest expense as a percentage of operating income. This percentage is consistently low for Williams Sonoma which indicates a durable competitive advantage. Having low financial leverage makes this a safe business.
Income taxes paid are an indicator of truthfulness of a company. Companies tend to alter financial statements to show that they’re earning more money than they are. But, deducting 35% from pre-tax operating income should equal the amount paid in income tax. The tax rate for Williams Sonoma has fluctuated a little bit, which is something Warren tries to avoid.
Net earnings should trend upward. This trend indicates a durable competitive advantage. As a percentage of revenue, net earnings should be more than 20%. The consistent upward trend is true for Williams Sonoma. Over the last five years, there is an upward trend in this percentage, however the most recent is 12.98% which is far below 20%. The range that Williams Sonoma falls in tells us that the industry is one that businesses are searching for the advantage in but they haven’t found it yet.
The general rule is the more a company earns per share, the higher the stock price. Consistency and an upward trend (see the trend here?) is exactly what we’re looking for. The upward trend indicates products that don’t need to go through expensive change and the economics are strong enough for the company to advertise and expand or do stock buybacks. Williams Sonoma’s earnings per share are trending upwards at a steep rate.
Balance Sheet
The next stop for Buffett is the balance sheet. The balance sheet is a snapshot of the assets, liabilities, and stockholders’ equity for a particular date. A common valuation statistic, book value or net worth, is found by subtracting liabilities from assets. This figure is also equal to stockholders’ equity.
Total assets show how efficiently a company is using its assets. ROA measures this efficiency. Abnormally high ROA can indicate vulnerability in the advantage, but Williams Sonoma’s ROA has been increasing (aside from the slight dip in 2020) and is at a healthy 24.15%.
Cash and short term investments can be a good thing to have. The catch is how much debt is paired with it and where did the cash come from? In 2020, the company had much more cash than in any of the other five years presented below. This was due to the pandemic and the ability of Williams Sonoma to shift to an online retail environment. Since then, the cash has decreased significantly. The amount of debt that the company holds is substantial in relation to cash, so we will stay on the lookout for that.
Net earnings and inventory are both on the rise over the last five years which is a sign of a durable competitive advantage. As sales increase, inventory needs to as well for the orders to be fulfilled.
Net receivables are useful when comparing companies in the same industry. A low percentage of net receivables compared to gross sales is an advantage. Williams Sonoma’s is 1.42% for 2022.
The higher the current ratio, the more liquid the company. Over one is considered good and under one is considered bad. Interestingly, the companies with durable competitive advantages seem to have ratios less than one. This means that these companies have high earning power and can pay off their current liabilities easily and they can pay out hefty dividends. The current ratio for Williams Sonoma is consistently over one which indicates high liquidity.
Property, plant, and equipment are things that companies with durable competitive advantages don’t need to constantly spend money on to stay competitive. Williams Sonoma brought in around 4 times more than it spent on PPE in 2022, which is a good sign. Having a consistent product that doesn’t need to change means consistent profits.
Goodwill and intangibles are sometimes grouped together. Goodwill appears when the company purchases another business for above book value (indicating a competitive advantage). Intangibles are things like brand name and patents that aren’t physical assets but that add considerable value to the company. Williams Sonoma’s stayed at $85 million and recently decreased to $77 million.
Having more short-term debt than long-term debt is a dangerous game to play. While being aggressive can make a lot of money, in the instance of sudden shifts in the market and lenders needing their money back, you’re in trouble. Williams Sonoma has consistently had far less short term than long term debt, which makes it easy for them to stay protected.
Total current liabilities is used in the calculation of the current ratio which is at the start of this section.
The long-term debt of Williams Sonoma is not very high. Companies with a long-term competitive advantage tend to carry very small amounts of long-term debt because they are so profitable that they are self-financing, as Warren calls it. The consistently low long-term debt is a sign of a durable competitive advantage.
The debt to shareholders’ equity ratio identifies whether a company uses debt to finance operations. However, a more useful measure is the treasury stock adjusted ratio, which I included below. Typically, below .80 is a good thing for competitive advantage but Williams Sonoma has values all above 1.0 which shows a high amount of debt financing.
As we know, common stock represents ownership in the company. These figures are below. Anything in excess of the par value is added to the balance sheet as “Additional Paid in Capital” which is listed below common stock. A note about preferred stock since it is not listed here: Williams’ Sonoma does not have any preferred stock. This is an indicator of a durable competitive advantage because these companies tend not to have debt.
Retained earnings is the net earnings of the company that is not used for dividends or to buy back company shares. Each year listed here for Williams Sonoma shows growth in retained earnings which is growth of the company’s net worth. The more a company retains earnings, the faster it grows the pool, and this increases the growth rate in the future.
Companies have two options for stock that they buy back. The company can cancel it or keep it for later. Treasury stock is listed in negative values because it is a deduction of shareholders’ equity. As stated earlier, companies with a durable competitive advantage have extra cash and they buy back their stock with it. Essentially, this decreases equity and increases return on equity. A history of buying back shares is something Williams Sonoma has and this indicates a durable competitive advantage.
Shareholders’ equity is also known as the net worth or book value of the company. It allows us to calculate the return on shareholders’ equity which shows the efficiency in allocating shareholders’ money. High returns are a good thing and they drive the price of the stock up. The increase in WSM stock price aligns with the increase of return on equity over the last five years.
More Information about Williams-Sonoma, Inc.
I chose Williams Sonoma because it’s a store that I must walk through whenever I see it. The store atmosphere and the reputation are great, and I always enjoy looking at what they have in stock. It’s also a go-to for gifts for my friends and family that like to cook. Buffett refers to a company with a durable competitive advantage as one that will make us rich. A key indicator of one of these businesses is one that sells a unique product and owns a part of the consumer’s mind. When you think about adding items to a wedding registry or a housewarming wish list, Williams Sonoma is more than likely one of the websites you’ll visit to make your list. This effect that the company has on consumers, in addition to selling high end brands like Al-Clad and Le Creuset, allows it to put a steep price tag on its products.
Within the retail sector, the company is doing well and has and is expected to continue growing in the coming years. Companies including Crate and Barrel and Sur La Table are major competitors with Williams Sonoma. They also sell kitchenware and small home essentials. It is very difficult for new companies to start up in this sector due to brand loyalty and economies of scale. Williams Sonoma owns brands such as Pottery Barn, West Elm, and Rejuvenation, which has built economies of scale for the company in terms of procurement and relationships with manufacturers that will be hard for new companies to replicate. The company has been selling kitchenware for 68 years and has adapted to consumer preferences shifting to online retailers while maintaining an enjoyable experience at the brick-and-mortar storefronts.
The primary growth driver of the company is business-to-business which allows Williams Sonoma to furnish other businesses like hotels and restaurants. This produces large volumes of sales and creates business relationships with the companies that they sell to. It is also a digital-first company, so most sales to consumers are through the company’s online retail website.
Williams Sonoma’s debt to equity ratio is above Buffett’s preferred 0.8, indicating a high degree of financial leverage. However, about 50% of total assets are in PPE which is a very high degree of operating leverage and shows high capital intensity.
To consider whether I would buy or sell the stock today, I have to consider my estimate of the intrinsic value and whether there’s a price to value gap. As of March 2024, the PE ratio of WSM is 21.4 and the most recent EPS is $14.55. Multiplying these together to get a value estimate is $311.37 per share. Right now, it’s trading for $314.02 per share, so it is currently overpriced using this valuation method. Using price to book (industry average PBV and WSM BV/share), the fair value is $58.84 which is quite far below the market price. Using DDM, the value is $369.29, which is above the market price. Every valuation method gives a different answer and none of the models seem to make more sense than the other ones. Finding a correct intrinsic value for a stock is extremely difficult and following the contradicting methods of academic finance doesn’t seem to get us very far in terms of finding an accurate value.
Depending on what method you use, there is either a positive or negative price to value gap. Using the first method, the stock is only overpriced by $2.65. For the second method, it’s overpriced by $255.18. With the third model, the stock is underpriced by $55.27. Based on these valuation methods, it’s hard to tell whether I should buy or sell today, but I think I would hold on to the stock if I already had some or I would sell it if I had to make that move. I don’t think it’s a good time to buy because Warren warns against buying when the company is at an all-time high PE ratio, which WSM is. I don’t think it’s time to sell right now and I would hold on to it for a little bit longer before selling. The rule that Buffett uses is when its PE is 40 or more, then it’s time to sell. WSM is sitting at 21.5 and the closest it has been to that in recent years was In 2015 at 20.67. The main reason I would wait is because the company has excelled in the online retailing aspect which it took advantage of during COVID and it’s still trending upward. The industry is also cyclical, and it can be expected to outperform going into an economic expansion which is another reason to wait.
