Many of Berkshire shareholders are not into the numbers but Charlie and Warren Buffett offers analysis approach to investors seeking numbers.
A. Aesop and Inefficient Bush Theory
“a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge & how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush—and the maximum number of the birds you now possess that should be offered for it.
An investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights. We can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners.
B. Intrinsic Value, Book Value, and Market Price.
Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. It is not that simple to calculate the value because of the discounting rate that you can use varies. The percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value.
C. Look-Through Earnings
Generally accepted accounting principles require full consolidation of sales, expenses, taxes, and earnings of business holdings more than 50% owned. Full inclusion of underlying earnings from another class of holdings, companies owned 20% to 50% (usually called “investees”), also normally
occurs. For holdings representing less than 20% ownership of another corporation’s voting securities. Only dividends received from such holdings will be included.
D. Economic versus Accounting Goodwill
Depreciation charges and amortization charges are not the same. With rare exceptions, depreciation is an economic cost
every bit as real as wages, materials, or taxes. We do not think so-called EBITDA (earnings before interest, taxes, depreciation and amortization) is a meaningful measure of performance. Managements that dismiss the importance of depreciation—and emphasize “cash flow” or EBITDA —are apt to make faulty decisions, and you should keep that in mind as you make your own investment decisions.
E. Owner Earnings and the Cash Flow Fallacy
“Cash Flow” is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them the average annual amount of capitalized expenditures is always significant. Cash flow numbers are frequently used by marketers of businesses and securities in attempts to justify the unjustifiable (and thereby to sell what should be the unsaleable).
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