Warren Buffett released his 2018 annual letter to Berkshire Hathaway shareholders last weekend which, of course, prompted investors and journalists to set aside their normal Saturday morning activities to analyze the Oracle’s words in great detail. Since the mid 1980s, Mr. Buffett has opened the letter with a statement regarding Berkshire’s change in book value per share. Longtime readers immediately noticed that this convention was missing from the 2018 letter. Readers quickly learned that this omission was not an oversight but driven by fundamental changes in how Mr. Buffett views book value at Berkshire:
Long-time readers of our annual reports will have spotted the different way in which I opened this letter. For nearly three decades, the initial paragraph featured the percentage change in Berkshire’s per-share book value. It’s now time to abandon that practice.
The fact is that the annual change in Berkshire’s book value – which makes its farewell appearance on page 2 – is a metric that has lost the relevance it once had. Three circumstances have made that so. First, Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses. Charlie and I expect that reshaping to continue in an irregular manner. Second, while our equity holdings are valued at market prices, accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years. Third, it is likely that – over time – Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value. The math of such purchases is simple: Each transaction makes per-share intrinsic value go up, while per-share book value goes down. That combination causes the book-value scorecard to become increasingly out of touch with economic reality.
In future tabulations of our financial results, we expect to focus on Berkshire’s market price. Markets can be extremely capricious: Just look at the 54-year history laid out on page 2. Over time, however, Berkshire’s stock price will provide the best measure of business performance.Warren Buffett’s 2018 Letter to Shareholders
Those who have followed Berkshire Hathaway for many years will understand that abandoning book value as a performance metric is a very big deal. Mr. Buffett has long viewed percentage changes in book value per share over time to be a very rough proxy for changes in intrinsic value. Although he has been stating that book value understates intrinsic value for decades, the rate of change in book value was thought to be a relevant metric until now. In fact, Berkshire’s stock repurchase program was limited to only permit repurchases below 120 percent of book value until the policy was changed in July 2018.
Is the Change Logical?
Mr. Buffett points out that a growing portion of Berkshire’s value is attributable to operating businesses rather than marketable securities. Marketable securities are carried at market value on Berkshire’s books. In a hypothetical scenario where all of Berkshire’s assets consist of marketable securities, book value would represent the current market value of what Berkshire owns and would be an excellent proxy for Berkshire’s intrinsic value. However, the value of operating businesses are carried on Berkshire’s books at the original purchase price subject to being marked down if the goodwill paid for the business at the time of acquisition becomes impaired. No matter how much economic goodwill is added to an operating business, it is never marked up on Berkshire’s books. As a result, over time, successful acquisitions, such as Berkshire’s 2010 purchase of BNSF, will tend to increase the gap between book value and intrinsic value.
The situation related to repurchases is even more interesting and, perhaps, not intuitive to most observers of the company. Repurchases of stock above book value have the effect of reducing book value per share. Let’s examine why.
When a company repurchases stock, both assets and shareholders’ equity on the balance sheet declines. When Berkshire repurchased $1.346 billion of stock during 2018, that amount is directly deducted from the company’s cash balance. Shareholders’ equity also declines by $1.346 billion reflected in the treasury stock account. In exchange for the $1.346 billion, Berkshire retired 1,217 A shares and 4,729,147 B shares. Since each A share is economically equivalent to 1500 B shares, Berkshire repurchased 4,370 A share equivalents, which means that the average price paid was slightly more than $308,009 per share.
At December 31, 2018, Berkshire’s shareholders’ equity was $348.703 billion and there were 1,640,929 A equivalent shares outstanding, indicating that book value per A share was $212,503. Now, consider an alternative scenario where Berkshire did not repurchase any shares in 2018. Under this scenario, shareholders’ equity would be $1.346 billion higher at $350.049 billion and there would be an additional 4,370 A equivalent shares outstanding for a total of 1,645,299 A shares, and book value per A share would have been $212,757.
The result: If Berkshire had not repurchased any stock in 2018, book value per A share would have been $254 higher at the end of the year!
Did Warren Buffett suddenly lose his mind and purposely do something to destroy $254 of value per share? If you believe that Berkshire Hathaway is only worth book value, then value was indeed destroyed because Mr. Buffett paid a premium to book value to retire those shares. That premium is the reason that book value per share declined. However, if Berkshire’s intrinsic value is higher than the price paid for repurchases, then the intrinsic value of remaining shares actually increased even though book value decreased. The result is a wider gap between intrinsic value and book value for the remaining shares.
Based on his 2018 letter to shareholders, Mr. Buffett believes that Berkshire will be a significant repurchaser of its own shares in the years to come. The math above demonstrates that significant repurchases will, over time, increasingly distort book value. Management might be adding value for shareholders by repurchasing stock below intrinsic value, but above book value. But book value per share will decline as a result.
In 2018, Mr. Buffett promoted Ajit Jain and Greg Abel to Vice Chairman positions and it is likely that one of these men will be the next CEO of Berkshire Hathaway. Continuing to use changes in book value as a rough proxy for changes in intrinsic value would create incentives for the future CEO to NOT repurchase any stock even if shares are available below intrinsic value (but above book value). The result could be a sub-optimal situation where managers decide to pay dividends instead of repurchasing stock. This would create negative tax consequences for shareholders. Although both Mr. Jain and Mr. Abel are excellent executives, it is a bad practice to use a metric to measure performance that will be negatively impacted by value-adding moves such as repurchases of stock below intrinsic value. This is likely the main reason for Mr. Buffett’s abandonment of book value. The rate of change in book value is now very unlikely to be used as a performance metric for compensation of Berkshire’s next CEO.
The “Gotcha” Moment!
Mr. Buffett has long argued against the practice of changing the goalposts after the game has started. In other words, changing the metrics by which management is judged should be looked upon with great skepticism. However, it is not logical to say that the goalposts should never be changed regardless of changes in circumstances. The important question is whether the change is logically defensible.
Some observers have implied that Mr. Buffett’s abandonment of book value signals an abrupt shift designed to obscure the fact that book value only progressed by a modest amount in 2018 and has slowed significantly since Berkshire’s earlier decades. However, these observers probably have not carefully studied the 42 years of letters to shareholders available on Berkshire’s website. In fact, Mr. Buffett has been warning about the limitations of book value for well over three decades. The following excerpt from the 1983 letter to shareholders is a typical example:
We report our progress in terms of book value because in our case (though not, by any means, in all cases) it is a conservative but reasonably adequate proxy for growth in intrinsic business value – the measurement that really counts. Book value’s virtue as a score-keeping measure is that it is easy to calculate and doesn’t involve the subjective (but important) judgments employed in calculation of intrinsic business value. It is important to understand, however, that the two terms – book value and intrinsic business value – have very different meanings.
Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.
An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously – from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value.Warren Buffett’s 1983 Letter to Shareholders
Those of us who have read all of Mr. Buffett’s letters know that the distinction between book value and intrinsic value has always been something he has made an effort to explain. Over the past few decades, and especially since the turn of the century, Berkshire has transformed from a company dominated by marketable securities to one dominated by operating companies. As Mr. Buffett’s letters explain, the intrinsic value of these operating businesses today have next to no relationship with the historical amount they are carried on Berkshire’s books.
As long as Berkshire was not a large repurchaser of its own shares, the concept of book value retained some utility because the rate of change in book value in any given year could serve as a rough proxy of changes in intrinsic value. However, the possibility of large repurchases in the coming years will make the utility of book value increasingly suspect. If one runs the same numbers as shown above for 2018 but assumes $13 billion of repurchases instead of $1.3 billion, the distortion in book value per share for the year will become more noticeable. It is very possible that Berkshire will deploy tens of billions of dollars toward repurchases over the next several years. Book value will become distorted and retaining its use would not only potentially mislead investors but create bad incentives for future CEOs to shun value adding repurchases. The change is justified and probably overdue.
A note on the impact of dividends on book value
Alert readers will note that if Berkshire had paid out the $1.346 billion in dividends to shareholders rather than repurchase 4,370 A shares in 2018, book value would have been even lower at the end of the year. The cash outflow on the asset side of the balance sheet would have been offset by an equal reduction to retained earnings. Each of the 1,645,299 A share equivalents would have received about $818 in dividends and book value would have been about $211,939 at the end of 2018. Would shareholders have been better off with $818 in their pockets (pre-tax) and a share with book value of $211,939? They would only be better off if Berkshire had overpaid for the shares it repurchased. As long as the repurchases are made below intrinsic value, continuing shareholders are better off than if Berkshire pays out an equivalent amount as dividends.
Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.