In his letter to shareholders, Buffett has stressed over and over again that the great business is the one which generate cash and consistently earn above average return on capital. However, the investors have to identify and leave out all the noise along the way of the financial statements to get to the true economic earning number.
Warren Buffett does not care about accounting consequences when purchasing the business, the true economic reality counts. He’d rather purchase $2 of earnings that is not reportable by Berkshire under GAAP than to purchase $1 of earnings which can be reported on the book to shareholders. His experience has shown that the unreported but real earnings can be fully reflected through capital gains. Normally companies often report the consolidated numbers, (especially those with several different business segments) but those numbers might reveal quite little about the true economic performance. He and Charlie Munger often ignore those consolidated numbers.
A lot of investors (even value investors) care about the book value and the ratio of P/B. However, it has its own faults. There are a gap between book value (the reported accounting number) and the intrinsic value. Buffett has mentioned that book value is an accounting concept, recording the accumulated financial input from contributed capital and retained earnings. Whereas intrinsic business value is the economic concept, estimating the future cash output discounted to present value. Book value is what has been put in, intrinsic value estimates what can be taken out.
He related to the example of the children going to colleges. Assume that you spend the same amount putting two children to college. The book value of each child’s education would be the same. But the present value of the future payoff might totally different with each of the two children – they can range from zero to many times the costs of education. Buffett took over Berkshire Hathaway in 1965, at that time, the book value of the company was $19.46 per share, and he considered that number considerably overstated the intrinsic value. All the assets were in machine equipment and textile that couldn’t earn anything close to the appropriate rate of return. So it is like to invest into the largely-wasted education.
However, in 1983, Buffett noted that Berkshire Hathaway intrinsic value has considerably exceeded its book value. There are two main reasons for that: First because the GAAP require common stocks held by insurance subsidiaries are stated on the books at market value, but other stocks Berkshire owns carried at lower of aggregate cost or market. At the end of 1983, the marketable securities group had exceed its initial cost of $70 million pre-tax or $50 million after tax. But the gap couldn’t be reflected fully in the financial statement or book value, even though it should be in the calculation of intrinsic value. Second, Berkshire owned several business that possesses economic goodwill (which should be included in the real business value) far larger than the accounting goodwill that is carried in its balance sheet, reflecting in the book value.
At the beginning of his career, Warren Buffett was taught to favour tangible assets and to shun businesses whose value depended mainly on economic goodwill. That has led him to many mistakes of omission he said, although relatively few of commission. Keynes has identified Buffett’s problem well: “The difficulty lies not in the new ideas but in escaping from the old ones”.
Other discussion by Warren Buffett:
Warren Buffett: Non-controlled earnings and acquisition
Warren Buffett: Accounting And Bond Investment Of Insurers[/color][/size]
Warren Buffett: Discussion on Equity Value Added
Warren Buffett does not care about accounting consequences when purchasing the business, the true economic reality counts. He’d rather purchase $2 of earnings that is not reportable by Berkshire under GAAP than to purchase $1 of earnings which can be reported on the book to shareholders. His experience has shown that the unreported but real earnings can be fully reflected through capital gains. Normally companies often report the consolidated numbers, (especially those with several different business segments) but those numbers might reveal quite little about the true economic performance. He and Charlie Munger often ignore those consolidated numbers.
A lot of investors (even value investors) care about the book value and the ratio of P/B. However, it has its own faults. There are a gap between book value (the reported accounting number) and the intrinsic value. Buffett has mentioned that book value is an accounting concept, recording the accumulated financial input from contributed capital and retained earnings. Whereas intrinsic business value is the economic concept, estimating the future cash output discounted to present value. Book value is what has been put in, intrinsic value estimates what can be taken out.
He related to the example of the children going to colleges. Assume that you spend the same amount putting two children to college. The book value of each child’s education would be the same. But the present value of the future payoff might totally different with each of the two children – they can range from zero to many times the costs of education. Buffett took over Berkshire Hathaway in 1965, at that time, the book value of the company was $19.46 per share, and he considered that number considerably overstated the intrinsic value. All the assets were in machine equipment and textile that couldn’t earn anything close to the appropriate rate of return. So it is like to invest into the largely-wasted education.
However, in 1983, Buffett noted that Berkshire Hathaway intrinsic value has considerably exceeded its book value. There are two main reasons for that: First because the GAAP require common stocks held by insurance subsidiaries are stated on the books at market value, but other stocks Berkshire owns carried at lower of aggregate cost or market. At the end of 1983, the marketable securities group had exceed its initial cost of $70 million pre-tax or $50 million after tax. But the gap couldn’t be reflected fully in the financial statement or book value, even though it should be in the calculation of intrinsic value. Second, Berkshire owned several business that possesses economic goodwill (which should be included in the real business value) far larger than the accounting goodwill that is carried in its balance sheet, reflecting in the book value.
At the beginning of his career, Warren Buffett was taught to favour tangible assets and to shun businesses whose value depended mainly on economic goodwill. That has led him to many mistakes of omission he said, although relatively few of commission. Keynes has identified Buffett’s problem well: “The difficulty lies not in the new ideas but in escaping from the old ones”.
Other discussion by Warren Buffett:
Warren Buffett: Non-controlled earnings and acquisition
Warren Buffett: Accounting And Bond Investment Of Insurers[/color][/size]
Warren Buffett: Discussion on Equity Value Added
