"Accounting" vs "Economic" Earnings: Berkshire Shareholder Letter Highlights

Here's another excerpt from the 1982 Berkshire Hathaway Shareholder Letter:

...financial statements reflect "accounting" earnings that generally include our proportionate share of earnings from any underlying business in which our ownership is at least 20%. Below the 20% ownership figure, however, only our share of dividends paid by the underlying business units is included in our accounting numbers; undistributed earnings of such less-than-20%-owned businesses are totally ignored.

Buffett later adds...

We prefer a concept of "economic" earnings that includes all undistributed earnings, regardless of ownership percentage. In our view, the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used - and not by the size of one's ownership percentage. If you have owned .01 of 1% of Berkshire during the past decade, you have benefited economically in full measure from your share of our retained earnings, no matter what your accounting system. Proportionately, you have done just as well as if you had owned the magic 20%. But if you have owned 100% of a great many capital-intensive businesses during the decade, retained earnings that were credited fully and with painstaking precision to you under standard accounting methods have resulted in minor or zero economic value. This is not a criticism of accounting procedures. We would not like to have the job of designing a better system. It’s simply to say that managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.

In most corporations, less-than-20% ownership positions are unimportant (perhaps, in part, because they prevent maximization of cherished reported earnings) and the distinction between accounting and economic results we have just discussed matters little. But in our own case, such positions are of very large and growing importance. Their magnitude, we believe, is what makes our reported operating earnings figure of limited significance.

At least some familiarity with the limits (and flaws) of an accounting system is useful. The numbers reported in SEC filings often must be converted into something that makes economic sense. It'd be nice if there was some absolutely correct set of numbers, but the investing process always comes down to making sound estimates of reality. Each company and industry has specific challenges. Beware of false precision.

"Better to be vaguely right than exactly wrong." - Carveth Read*

You can figure out whether company XYZ has return on equity (ROE) in the 20-25% range or free cash flow (FCF) is ~$ 950-$975 million. It's fantasy to think you can calculate that the ROE is precisely 23.4% or that the FCF is $ 963 million. Getting to a meaningful rough approximation is what counts.

Enrico Fermi thought the ability to effectively estimate (often called a Fermi estimate or Fermi problem) was an important skill for scientists and engineers to master.

Here's a previous post for some additional background.

One example of Fermi's skills at estimating: a remarkably accurate estimate of the strength of an atomic bomb blast during the Trinity test (of course, the first test of its kind) was made based on the distance travelled by pieces of paper he dropped from his hand upon detonation.

I think it's as useful a skill for investing as he believed it to be for science and engineering.


Related post:
Munger on Accounting

* This quote is sometimes incorrectly attributed to John Maynard Keynes even though the original source is apparently Carveth Read.
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"Accounting" vs "Economic" Earnings: Berkshire Shareholder Letter Highlights
"Accounting" vs "Economic" Earnings: Berkshire Shareholder Letter Highlights
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