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Warren Buffett: The Cash Flow Fallacy and Business Equity Valuation

January 02, 2012 | About:
Back in 1986, Warren Buffett had commented on the accounting of the purchase of Scott Fetzer, a high-return and cash-cow business. He laid out the two sets of the financial statements: one was the old Scott Fetzer before the purchase, and the other was after the purchase, reported on a GAAP basis by Berkshire Hathaway (BRK.A)(BRK.B). He emphasized that the two financial sets had the same economic value, that is, the same sales, wages, taxes, etc., and both generated the same amount of cash flow for the business owners. The only thing that was different were the numbers in the income statement; in other words, it was accounting.

In the Scott Fetzer deal, Buffett paid $315 million for the net assets carried on the books at $172.4 million. So the premium was $142.6 million, and the P/B valuation was around 1.83x. So in the Scott Fetzer income statement reported by Berkshire, it need to reflect the premium amount in to the book. He said that the first step was to adjust the carrying value of current assets to current values. Normally this kind of practice didn’t affect the receivables, but the inventories. Buffett saw that Scott Fetzer's inventory was carried in the book at the discount of $37.3 million from the current value, so he moved $37.3 million from the premium to increase the level of inventory value back to the current value.

The next step came as the fixed asset value adjustment. In this case, the deferred taxes needed to be adjusted. The result was $68 million added back to fixed assets and $13 million eliminated from deferred tax liabilities. So a premium of $24.3 million was left to allocate further. Two more steps weren’t necessary in this case, such as the adjustment of intangibles to current values and liabilities restatement, which contributed from the changes in long-term debt and unfunded pension liabilities. The rest of the $24.3 million was assigned to goodwill.

To make a long story short, after all those adjustments in income statements and balance sheets, even though with the same company, made the number representations totally different before and after the purchase. The new financial set would generate higher assets due to the level of adjustment and goodwill, creating higher depreciation, leading to lower income. The total charges were around $11.6 million, so the income number would drop from $40.2 million to $28.6 million. In addition, because of the larger charge to earnings, the new net worth number of Scott Fetzer was reduced by the same amount of the charges. Buffett asked: “What does all this mean for owners? Did the shareholders of Berkshire buy a business that earned $40.2 million in 1986 or did they buy one earning $28.6 million? Were those $11.6 million of new charges a real economic cost to us?”

That led Warren Buffett to discuss the term “owner earnings.” He defined it as “the (a) reported earnings + (b) depreciation, amortization, depletion and certain other non-cash charges – (c) average annual amount of capitalized expenditures for plant and equipment, etc that the business required to fully maintain its long-term competitive position and its unit volume. (if the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)”

Buffett considered this “owner earnings” figure relevant for valuation purposes for both stock purchases and business buyers. Using this for the Scott Fetzer case would result in the same owner earnings. Normally many business managers know that in order to keep the competitive advantage of a business, they have to invest more than the (b) figure. And when (c) is exceeded (b), GAAP earnings overstate owner earnings. The outstanding case was the oil industry. Buffett commented “Had most major oil companies spent only (b) each year, they would have guaranteed their shrinkage in real terms.”

Normally, a lot of people talked about "cash flow” as equivalent to (a) + (b), but normally they did not subtract (c). Buffett said that this might work as a rough number for some industries such as certain real estate businesses or any businesses which require huge initial capital outlay and only tiny outlays thereafter, such as bridge owners, toll roads or extremely long-lived gas fields. But that cash flow calculation would be meaningless in businesses of manufacturing, retailing, extracting and utilities because (c) is always a significant number. So, if the investor or company believes that the debt-servicing ability or equity valuation of an enterprise can be measured only by (a) + (b) without taking into account (c), it will face trouble. Any investors should keep this in mind as Buffett noted in this last point: “Accounting is an aid to business thinking, never a substitute for it.”

About the author:

Anh Hoang
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Visit Anh Hoang's Website


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Comments

MichaelServet
MichaelServet - 2 years ago
Now we can fast-forward to the present, and note that the accounting treatment for goodwill was changed in 2001, so we no longer have that amortization differential with acquisitions. Hence no similar explanation with the Burlington Northern purchase. See SFAS 142.

Also, you may want to read up on what's called 'purchase accounting'. Best regards/

steven149
Steven149 - 2 years ago
So say if investors need to take consideration of (c), they would have to pick a less maintenance cost business sector. That is because different business sector would have their own maintenance cost, some may have higher or less than average costs. The better approach is to pick the least maintenance cost companies in the least (c) sectors. Picking the most efficient ones is certainly right. But picking the least (c) sectors may need to be further justified.

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