Measuring profit performance

November 16, 2014

In 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.”