In addition to being one of the greatest stock pickers of all time, Warren Buffett (Trades, Portfolio) is fluent in the language of accounting. Indeed, he has famously said that understanding accountancy is essential to succeeding as an investor. Although there are certainly individuals who have made money in the markets without having a deep understanding of company financials, for value investors, understanding the balance sheet, income statement and cash flows should be a prerequisite. In his 1980 letter to shareholders, Buffett explained an important concept in accountancy - that of non-controlled ownership earnings.
How much of a stake?
In the letter, Buffett discusses what I have elected to call "three tiers of ownership," and how they affect the way that subsidiary companies report earnings. Although some of the specifics of how this reporting occurs have changed since the early 1980s, the overall idea is the same.
1) Ownership of a business where the stake is 50% or more. In this case, the parent company is required to fully consolidate all sales, expenses, taxes and earnings of its subsidiary, and to deduct earnings retained by minority ownership. Buffett used the example of Blue Chip Stamps to illustrate this.
2) Ownership of a business where the stake is between 20% and 50%. In this case, only the proportion of earnings ascribable to the parent company is recorded on the parent’s statements, omitting revenue and expenses. That is, if your firm owns 25% of a company with total earnings of $1 million, you would record earnings of $250,000. Importantly, the earnings are recorded regardless of whether they are distributed as dividends.
3) Ownership of a business where the stake is less than 20%. In this case, only earnings distributed as dividends are recorded on the parent’s statements.
What is the point of this accounting lesson? Well as I have said, it is important for value investors to be able to properly interpret financial statements, especially in cases where different ownership claims overlap.
But this part of the shareholder letter is also interesting because of what Buffett goes on to say - that to him, it does not matter whether the earnings of Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) subsidiaries and minority interests are recorded on its statements. At the time he was writing, Berkshire’s insurance business was going through a particularly strong period, and the market presented plenty of opportunities to buy companies at fair valuations. As a result, Berkshire was accumulating stakes in many businesses whose earnings would not be recorded on its income statement. This led to less than half of Berkshire’s earnings "iceberg" being visible, as Buffett put it.
I will leave it to the man himself to conclude this thought:
“The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage. This is true whether we determine the usage, or whether managers we did not hire - but did elect to join - determine that usage. (It’s the act that counts, not the actors.) And the value is in no way affected by the inclusion or non-inclusion of those retained earnings in our own reported operating earnings. If a tree grows in a forest partially owned by us, but we don’t record the growth in our financial statements, we still own part of the tree.
Our view, we warn you, is non-conventional. But we would rather have earnings for which we did not get accounting credit put to good use in a 10%-owned company by a management we did not personally hire, than have earnings for which we did get credit put into projects of more dubious potential by another management - even if we are that management."
Disclosure: The author owns no stocks mentioned.
Read more here:
- The Market Is Not Pricing in a Hard Landing for Boeing
- 2 Pieces of Investment Wisdom From Bill Ackman
- Mohnish Pabrai: Invest in Companies That You Understand
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