"Managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation."
- Warren Buffett (1982)
In most professional disciplines, going to the primary source is the best way to get an unblemished perspective on things. But thanks to a veritable tome of complicated accounting conventions that can obscure a company's substantive performance, the same can't be said of investing -- for the record, by "primary source" I mean a company's quarterly and annual financial statements filed with the Securities and Exchange Commission.
This is a point that Warren Buffett, the chairman and CEO of Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), made in his 1982 letter to shareholders. "Managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation," the 83-year-old billionaire wrote.
Accounting form vs. substance
While esoteric accounting rules are often used by executives to intentionally mask underperformance or to artificially inflate otherwise mediocre results, they can also convolute a company's success or failure even in the absence of wrongdoing. This was the position Berkshire found itself in at the beginning of the 1980s.
For much of the previous two decades, Berkshire had focused its (and its shareholders') attention on a very specific metric of success: operating earnings as a percent of beginning equity capital. "Management's objective is to achieve a return on capital over the long term which averages somewhat higher than that of the American industry generally," Buffett said in 1973.
While there's no doubt the Omaha-based conglomerate was successful at this, its large stakes in non-controlled companies like GEICO (at the time, Berkshire held only a minority stake in the insurance company) and The Washington Post, meant that its share of their earnings wouldn't be reflected in Berkshire's official results. And this wasn't just a nominal issue.
The magnitude of the distortion can be seen by looking at the performance of Berkshire's four largest holdings in 1982. That year, Berkshire reported operating earnings of $31.5 million, which amounted to 9.8% of its beginning equity capital. Meanwhile, its share of undistributed earnings from GEICO, General Foods, The Washington Post, and R.J. Reynolds Industries amounted to "well over $40 million."
As Buffett noted,
This number – not reflected at all in our earnings – is greater than our total reported earnings, which include only the $14 million in dividends received from these companies. And, of course, we have a number of smaller ownership interests that, in aggregate, had substantial additional undistributed earnings.
Fast forward three decades and Buffett's observation that accounting earnings can "seriously misrepresent economic reality" is abundantly clear. At the end of 2013, Berkshire's cost basis in its common stock portfolio was $56.6 billion. The market value, by contrast, was more than double that at $117.5 billion. That's a $61 billion gain not showing up in earnings. And, of course, this excludes the billions of dollars in dividends Berkshire has received from these companies throughout the years.
The Foolish takeaway
The point here is an important one. If you want to understand a business, it isn't enough to simply scan their regulatory filings on the SEC's website. One must also look beyond the veneer to the true sources of growth and profitability. Had you done this in 1982 with respect to Berkshire, perhaps you too would have enjoyed the subsequent 38,000% returns.
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John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.