Post of the Day
January 21, 2000

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Berkshire Hathaway

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Subject:  Re: About the new economy
Author:  DeliLama

"The problem, says Lev, is that the systems of accounting and financial reporting that are being used today date back more than 500 years."

Interesting that we should start looking to invent new ways to measure things just as they become increasingly overvalued, much as an extremely obese person might re-invent ways to measure weights just as they seem to be getting extremely large.

Nothing has changed. I see one long slow continuous improvement in computer based communications (that's my field) since the 1960s. Why are we suddenly trying to re-invent accounting?

What would happen if your local bank started talking about re-inventing accounting and how your money is represented in your account? Let's say they started talking about intangibles. It's a new age... and just because you've given them $10,000 doesn't mean that you should be able to get it back in the form of cash. They will return much of that $10,000 in the monetary units of dance and performace art. The act of counting is so old and obsolete.

"Look at the Standard & Poor's 500 -- 500 of the largest companies in the United States, many of which are not in high-tech industries. The market-to-book ratio of these companies -- that is, the ratio between the market value of these companies and the net-asset value of the company ( the number that appears on the balance sheet ) -- is now greater than six. What this means is that the balance-sheet number -- which is what traditional accounting measures -- represents only 10% to 15% of the value of these companies. Even if the stock market is inflated, even if you chop 50% off the market capitalization, you're still talking about a huge difference between value as perceived by those who pay for it day-to-day and value as the company accounts for it."

Normally, the huge difference between book value and price is due to the money generating power of the company. It shows up in the form of "goodwill" when a company purchases another company and attempts to represent this "value" in the world of accounting. It's not perfect, but there is simply no good way to represent intangibles in an objective mathematical way.

"But it sounds like we are fishing for some justification for higher prices."

But it sounds like we are fishing for some justification for higher prices. If you were to very convincingly show us that these companies are permanently worth increasingly large amounts of money relative to their projected earnings, then we might look for some way to understand why. But to begin with the assumption that they are worth more, and then to try to work that into accounting standards is not going to fly. In other words, you are saying these companies are currently priced very high, therefore we need to find some way to justify it.

"Managers don't have good numbers to refer to when deciding whether to back a project, or when assessing a project's performance."

Call me old fashioned, but I've always believed that making money was a good way to assess a project's performance in business.

"Are knowledge-based companies overvalued on the stock market? Are companies paying too much to acquire knowledge-based assets? These questions, says Lev, and more, cannot be adequately answered with today's accounting and financial-reporting methods. Accounting, in other words, no longer delivers accountability."

So making a profit is no longer a way to evaluate a company?

Ok, I accept that you're correct and that we can't use accounting any more. I also believe we should get rid of the stock market which is based on GAAP accounting ruled by the tyrannical FASB. So now let's all take our money and privately fund companies. Without a market to trade securities, you're stuck with whatever kind of company you start up with your own money. I've done this twice, so I can tell you that it's loads of fun, hardly any work, and money will fall from the sky when you use creative accounting.

Now, with your own company, you can be comforted by the fact that your new accounting techniques show that you own an extremely valuable technology based company. That's it, you've reached the goal line. You can go celebrate knowing that your accounting methods show vast intangible wealth in your pockets.

"But there's no limit to the number of people who can use AMR Corp.'s SABRE system at once: It works as well with 5 million people as it does with 1 million people. The only limit to your ability to leverage a knowledge asset is the size of the market."

"So that's how intangible assets can create extraordinary value."

Of course, we won't tell you that if this reservation system really does make a lot of money, everybody and their brother will be making reservation systems and your margins will fall to the depths of hell.

I started working in the knowledge industry making a product that sold for $13,000 each. I now make the same product which is better, faster, and has huge amounts of additional R&D poured into it, and sells for around $10 and in volumes that are orders of magnitude higher and makes less money. Knowledge is hell.

"There's another downside of knowledge assets: Property rights are fuzzy.... The proliferation of thousands upon thousands of very costly patent-infringement lawsuits attests to the difficulty of defining and keeping property rights when you're dealing with knowledge."

Actually, that part of knowledge assets are not fuzzy at all. It's quite simple, really. Patents are like barganing chips. If someone comes along and claims you are violating their intellectual property, you simply dig through your patents and look for something they're doing that violates your own patents. You then cross license and move on. God help you if you don't have a lot of patents because, although there's usually a way around them, it's a pain in the rear to constantly redesign your product around other people's patents.

"Look at the extremely high prices that high-tech companies are paying to acquire smaller companies, as they look for knowledge assets that they can leverage."

Using inflated stock to buy other inflated stock isn't all that irrational.

"But when you're building a knowledge asset, you could quite possibly end up with nothing."

Boy, you got that right. I can't tell you how many really great engineer day care and training programs I've seen that had a profit return which can only be calculated by the increase in the engineers' salaries after being able to work on really glamorous technologies... in other companies, of course. Usually, the original company is so drained of resources, it can only stagger forward in sustaining mode. And who wants to work on that. I've always felt a certain bittersweet thanks to the investors who funded those black holes of cash loss.

"When a drug passes its clinical tests, huge value is created -- but there's no transaction. Nothing changes hands. Nobody buys anything, and nobody sells anything."

Of course we carefully ignore the R&D costs that allowed the drug to pass. And the R&D costs for all the other drugs that only succeeded in causing warts and flatulence.

"When software passes a beta-test, it suddenly becomes valuable"

So it had no value during integration testing.

"Oh, the world has known lots of companies that have destroyed value. History is littered with them."

"Or think about how value is destroyed: When a big, old company is late in figuring out how to enter the world of e-commerce, huge value is destroyed -- but there's no transaction."

Oh, the world has known lots of companies that have destroyed value. History is littered with them. And I think the future won't be any different.

"The second barrier to change is an informal coalition that opposes any change to the current system. Managers love the current system. They don't want to put anything on the balance sheet that may turn out to be worthless."

I don't even need to comment on this one. It speaks for itself.

"For example, I just finished studying roughly 1,500 companies -- all of which have significant R&D investments. About a quarter of these companies are systematically undervalued by their investors. And many of them are computer, biotech, and software companies with substantial R&D but below-average earnings."

As an engineer, I offer you a teary eyed thank you. All those investors should listen to these words of wisdom and pay for me to work on fun projects that return below-average earnings. Having blown ten digit sums on projects that were a real blast and had a combined 5 digit total return, I have the experience needed. I'm ready to go, baby, just give me some more millions!

But wait a minute. Earlier I thought that the value of companies was tied precisely to their stock price (at least the arguments made that assumption). Therefore, these companies are not undervalued. Unless of course we create a valuation function that is the maximum of all possible valuations. Therefore while it's possible to undervalue a company, it is mathematically impossible to overvalue a company.

"Structural capital is a unique way of doing business. In the case of Dell Computer, the company doesn't produce computers that are better than other companies' computers, but the way in which it markets its computers is entirely different."

Damn! And I thought some other company could just come along and market computers the same way as Dell. I now see that's not possible with this new way of accounting. The earnings from this new Dell competitor won't even show up, nor will the reduction in Dell's margins.

"So the question is, Who can survive the shakeout that invariably hits every industry? The survivors are those companies that have good technology, because they have the ability to innovate."

Like Microsoft over Apple. Wintel over IBM. Compaq over Digital. VHS over Beta.

DeliLama

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