See’s was bought early in 1972 for $25 million, at which time it had about $8 million of net tangible assets (accounts receivable was classified as tangible assets). This level of tangible assets was adequate to conduct the business without the use of leverage (i.e debts), except for short periods seasonally. At that time, See’s was earning was about $2 million after tax, and Buffett thought that such earnings can be seen as conservatively representative of future earning power in constant 1972 dollars. So Warren Buffett bought See’s at the valuation of around 3 times book and 12.5 times earnings.
That was Buffett’s first lesson: “Businesses logically worth far more than net tangible assets when they can be expected to earn on such assets considerably more than market rates of return. The capitalized value of this excess return is economic Goodwill. “
In that year, relatively few businesses could be expected to consistently earn 25% after-tax on net tangible assets, and See’s could do that with conservative accounting and no borrowing. “And it was not the fair market value of inventories, receivables or fixed assets that produced premium rates of return. Rather, it was the combination of intangible assets, particularly a pervasive favourable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.” Buffett realized that the consumer franchises are the prime source of economic Goodwill. There are two other sources, such as the governmental franchise, but unregulated (television for example) and low-cost producers in the industry.
For See’s, the economic Goodwill would keep increasing because of inflation. Just think about the comparison of See’s and a more mundane business. When See’s was acquired in 1972, it was earning $2 million on $8 million of net tangible assets, and we assumed that mundane business was earning $2 million as well, but on higher value of net tangible asset, $18 million. For the latter, it was earning 11% on required tangible assets, and that mundane business would possess little or no economic Goodwill. The business like that can be sold for around $18 million, equal to the value of net tangible assets (P/B = 1). However, Buffett paid $25 million for See’s, even though it has the same earnings and a much lower asset base.
Now if there is inflation which causes the price level to be double, both businesses would need to double their nominal earnings (to $4 million) just to keep pace with inflation. And logically, the business only needs to sell the same number of units for double earlier prices and assuming the same profit margin, the profit will double as well.
“Crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly in inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not prosperity of the owner.”
So for See’s, the new capital to be added was $8 million, whereas the other business was $18 million more. After the new investment was coming in and both businesses had earned $4 million, the mundane business might be still worth the value of its net tangible assets ($36 million). Basically, the owner has gained only a dollar of nominal value for every new dollar invested, whereas See’s might be worth $50 million if valued on the same basis as it was at the time of Buffett’s purchase. So the result for See’s owner was gaining $25 million in nominal value while owners were putting up $8 million in additional capital (pver $3 gain for each $1 investment).
Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses with little tangible assets are simply hurt the least. That was against traditional wisdom, which stated that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets. However, that traditional thinking was not so true. “Asset-heavy businesses generally earn low rates of return – rates can’t provide enough capital to fund the inflationary needs of existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.”
Last but not least, the indicator to know the attractiveness level of the business: “What a business can be expected to earn on unleveraged net tangible assets… is the best guide to the economic attractiveness of the operation. It is also the best guide to the current value of the operations’ economic Goodwill.”