Valuation Lessons from Warren Buffett’s Most Recent Shareholder Letter
By Ethan Hitchcock, CPA/ABV, ASA, Valuation and Forensic Services Manager
Every year, one of the most widely read pieces on Wall Street is the Berkshire Hathaway, Inc. shareholder letter written by Warren Buffett. The letter pulls back the curtain on Buffett’s investment process and dispenses invaluable lessons from one of the richest people in the world and one of the greatest investors of all time. Buffett’s 2018 letter touched on several critical issues that impact business owners and valuation professionals alike.
Lower taxes = higher value
Taxes are a lot like gravity – most people have a basic understanding of the concepts but when it comes down to it, very, very few people could explain the mechanics of either. For example, the ratio of people who have heard of the formula “E=mc²” to those that could explain the warping of spacetime is probably equivalent to the ratio of people who have heard of the Tax Cuts and Jobs Act (the “TCJA”) to those that could explain why their taxes changed. Further, intense focus on several key provisions of the TCJA such as the qualified business income deduction on pass-through entities or changes to the treatment of alimony has seemingly obscured the forest for the trees: lowering taxes increases the value of a business.
Perhaps no one understands the value generated by lower taxes better than Buffett. Buffett’s description of taxes and the impact of lower taxes on value is elegant in its simplicity:
Begin with an economic reality: Like it or not, the U.S. Government “owns” an interest in Berkshire’s earnings of a size determined by Congress. In effect, our country’s Treasury Department holds a special class of our stock – call this holding the AA shares – that receives large “dividends” (that is, tax payments) from Berkshire. In 2017, as in many years before, the corporate tax rate was 35%, which meant that the Treasury was doing very well with its AA shares. Indeed, the Treasury’s “stock,” which was paying nothing when we took over in 1965, had evolved into a holding that delivered billions of dollars annually to the federal government.
Last year, however, 40% of the government’s “ownership” (14/35ths) was returned to Berkshire – free of charge – when the corporate tax rate was reduced to 21%. Consequently, our “A” and “B” shareholders received a major boost in the earnings attributable to their shares.
This happening materially increased the intrinsic value of the Berkshire shares you and I own.
Operating income is key
When valuing a company, especially a small, privately-held one, determining the correct cash flow stream is key. Revenues and expenses that are non-operating (e.g., gains or losses on investments held by an operating business) or non-recurring (e.g., restructuring charges) can significantly impact a company’s financial results and obscure the true performance of the company. The Oracle of Omaha is spot on when he recommends that one “focus on operating earnings, paying little attention to gains or losses of any variety.” Operating income is the heartbeat of a business and listening closely will give you a much clearer picture of the company’s financial health.
Don’t be afraid to call it like you see it
One of the hallmarks of Buffett’s letters is his ability to blend financial lessons with folksy wisdom. When discussing the various explanations management gives for ignoring expenses such as stock-based compensation and restructuring costs when calculating adjusted EBITDA, Buffett defers to the judgement of Honest Abe:
Abraham Lincoln once posed the question: “If you call a dog’s tail a leg, how many legs does it have?” and then answered his own query: “ Four, because calling a tail a leg doesn’t make it one.”
Abe would have felt lonely on Wall Street.
We would all be better served to follow Abe’s advice in business valuation, investing, and life in general.
The letter also touches on Buffett’s views on maintaining cash reserves (“I will never risk getting caught short of cash”), the downsides of debt (“At rare and unpredictable intervals, however, credit vanishes and debt becomes financially fatal”), and many other important points. If you haven’t already, I highly recommend you take 15 minutes to read the letter using the link above; there isn’t a more valuable way to spend your time.
Read more of our Valuation-related articles:
- Business Valuation Services: Top 10 Questions to Ask a Prospective Appraiser
- Tax Cuts and Jobs Act: Impact on Divorce
- “D-I-V-O-R-C-E' (Apologies To Tammy Wynette)
- Red Flags in Business Valuation Appraisals
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.