Category Archives: Profit performance measurement

Book value as proxy for intrinsic value

In his annual letter (February 26, 2011) to Berkshire Hathaway shareholders for Year 2010, chairman Warren Buffett shared his and Charlie Munger’s thoughts on intrinsic value as a measurement of performance:

“Charlie and I believe that those entrusted with handling the funds of others should establish performance goals at the onset of their stewardship. Lacking such standards, managements are tempted to shoot the arrow of performance and then paint the bull’s-eye around wherever it lands.

“In Berkshire’s case, we long ago told you that our job is to increase per-share intrinsic value at a rate greater than the increase (including dividends) of the S&P 500. In some years we succeed; in others we fail. But, if we are unable over time to reach that goal, we have done nothing for our investors, who by themselves could have realized an equal or better result by owning an index fund.

“The challenge, of course, is the calculation of intrinsic value. Present that task to Charlie and me separately, and you will get two different answers. Precision just isn’t possible.

“To eliminate subjectivity, we therefore use an understated proxy for intrinsic-value – book value – when measuring our performance. To be sure, some of our businesses are worth far more than their carrying value on our books…But since that premium seldom swings wildly from year to year, book value can serve as a reasonable device for tracking how we are doing.”

Recommended reading:

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

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

Warren Buffett’s thoughts on record earnings

dollarbillsfreeIn his letter to Berkshire Hathaway’s stockholders as far back as March 14, 1978 for FY2007, Warren Buffett has this to say about record earnings: “Most companies define “record” earnings as a new high in earnings per share. 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.”

This statement is worth repeating and highlighting: “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?

Here is Warren Buffett’s answer in the same letter to Berkshire Hathaway shareholders: “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.”

Recommended reading:

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

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

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