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Measuring profit performance

dollarsignIn his 1977 letter to Berkshire Hathaway shareholders, Warren Buffett said that “most companies define ‘record’ earnings as a new high in earnings per share”.
This measure is not appropriate in Mr Buffett’s views. “Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.”
What then is a more appropriate measure of managerial economic performance?
In the same 1977 letter, Mr Warren Buffett said: “Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.”
Giving an example, Mr Buffett said: “In 1977 our operating earnings on beginning equity capital amounted to 19%, slightly better than last year and above both our own long-term average and that of American industry in aggregate. But, while our operating earnings per share were up 37% from the year before, our beginning capital was up 24%, making the gain in earnings per share considerably less impressive than it might appear at first
glance.”
This view on the measurement of managerial economic performance was seen again in Warren Buffett’s letter to shareholders in 1979, when he said: “Measuring such results against shareholders’ equity with securities valued at market could significantly distort the operating performance percentage because of wide year-to-year
market value changes in the net worth figure that serves as the denominator. For example, a large decline in securities values could result in a very low ‘market value’ net worth that, in turn, could cause mediocre operating earnings to look unrealistically good. Alternatively, the more successful that equity investments have been, the larger the net worth base becomes and the poorer the operating performance figure appears. Therefore, we will continue to report operating performance measured against beginning net worth, with securities valued at
cost…”
“…The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place
upon earnings per share, and upon yearly changes in that figure.”

Recommended reading:
Berkshire Hathaway Letters to Shareholders, 1965-2013

How Warren Buffett picks marketable securities

wallstreetfreeWarren Buffett said in his letter to shareholders in the 1977 annual report that Berkshire Hathaway selected marketable equity securities in much the same
way it would evaluate a business for acquisition in its entirety.
Warren Buffett said then: “We want the business to be (1) one that we can understand, (2)
with favorable long-term prospects
, (3) operated by honest and
competent people
, and (4) available at a very attractive price.”
The fourth point, “available at a very attractive price”, was changed to “available at an attractive price” in his letter to shareholders in the 1992 annual report.
“We have seen cause to make only one change in this creed: Because of both
market conditions and our size, we now substitute an attractive
price’ for ‘a very attractive price’,” Warren Buffett said in the 1992 annual report.
The consistency of Berkshire Hathaway’s investment creed can be seen in Warren Buffett’s letter to shareholders in the 2007 annual report.
Warren Buffett said then: “Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.” “Charlie” refers to Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway.

Recommended reading:
Berkshire Hathaway Letters to Shareholders, 1965-2013

Who is Warren Buffett?

warrenbuffettstockfreeWarren Buffett (full name: Warren Edward Buffett) was born on August 30, 1930 in Omaha, Nebraska, United States. He is the chairman and chief executive officer of Berkshire Hathaway Inc, an American multinational conglomerate holding company headquartered in Omaha. Known to many as the Wizard of Omaha or the Oracle of Omaha or the Sage of Omaha, Warren Buffett is a strong believer of value investing, a belief which the legendary value investor steadfastly puts into practice at Berkshire Hathaway. Reflecting the great success of his value investment approach, Berkshire Hathaway’s 2013 Annual Report shows that “over the last 49 years (that is, since present management took over), book value has grown from US$19 to US$134,973, a rate of 19.7% compounded annually”. These are per-share book values. Berkshire Hathaway  describes itself as  a holding company owning subsidiaries that engage in a number of diverse business activities including insurance and reinsurance, freight rail transportation, utilities and energy, finance, manufacturing, services and retailing.

Warren Buffett is one of the best-known disciples of Benjamin Graham (May 8, 1894 – September 21, 1976), the father of value investing who co-authored the famous book, Security Analysis, with David Dodd. Warren Buffett has described the book as a road map for investing that he has been following.

Recommended reading:

(1) The Essays of Warren Buffett: Lessons for Corporate America, Third Edition

(2) Berkshire Hathaway Letters to Shareholders, 1965-2013