When most companies score their performance, they use metrics such as net income or sales -- figures you'd find on a company's income statement. But when Warren Buffett measures his performance at Berkshire Hathaway (BRK.A 0.48%) (BRK.B 0.44%), he does so differently, looking to the balance sheet to find the change in book value per share as a measure of his ability to add value for shareholders.

In his 2000 letter to shareholders, Buffett began including a table comparing Berkshire's book value growth to the returns of the S&P 500 in his letter to shareholders, making it obvious that Buffett views book value as one of the most important measures of his investing skills.

So why does Buffett focus on book value and its balance sheet when so many other companies talk about income statement measures such as their profit and loss? It all boils down to some relatively basic accounting.

Why other metrics fail

To understand why Buffett uses book value as a scorecard, you have to understand why other metrics, such as net income or sales, are an unreliable way to measure Berkshire's performance. Berkshire makes money in two basic ways: It owns companies outright, and it owns minority stakes in other businesses.

Warren Buffett at annual shareholders meeting.

Image source: The Motley Fool.

Consider the case of BNSF, a railroad business that Berkshire owns outright. The revenue BNSF generates moving stuff by rail is included in Berkshire's income statement as revenue, the costs of doing business are recorded as expenses, and the profit is included in Berkshire's net income. That's all very simple. The railroad's results, along with the results of other operating companies, are largely included in Berkshire's consolidated income statement.

But Berkshire also owns minority stakes in other businesses, which create value for Berkshire that isn't reported on Berkshire's income statement. Berkshire owns 400 million shares of Coca-Cola, for example. Every time Coca-Cola sells syrup to a bottler, it makes money for Berkshire, but it doesn't flow through Berkshire Hathaway's income statement as BNSF's earnings do.

Berkshire makes money on its Coca-Cola investment when the value of Coca-Cola stock increases. If Coca-Cola shares increase in value by $10 each, Berkshire Hathaway would score a $4 billion gain on its investment. Berkshire would report that its investments are worth $4 billion more on its balance sheet and then record a liability for capital gains taxes it would have to pay if it sold its shares of Coca-Cola stock. But none of this gain would appear in Berkshire's net income until the day Buffett decides to sell the stake in Coca-Cola, which may happen years from now, or never at all.

Why the change in book value matters most

So, now that we know that Berkshire's net income is basically meaningless -- it's volatile and excludes a lot of Berkshire's earnings power -- it's important to understand why the change in book value per share has meaning.

The two things that have the most impact on how much Berkshire's book value moves up or down over any span of time are:

  1. Retained earnings, which is all of the historic earnings from operating companies (BNSF, for example), plus realized gains on the investment portfolio (stocks it sold at a gain or loss), minus any dividends Berkshire has paid to its shareholders.
  2. Accumulated other comprehensive income, which is related to Berkshire's unrealized gains or losses on the investment portfolio. (Think gains on Coca-Cola stock that it hasn't sold.)

So, in essence, book value captures the money earned by Berkshire's operating units, profits on investments it has sold, and the money Berkshire earned on investments that it hasn't sold yet. It's a really comprehensive figure, whereas net income simply isn't.

But even book value isn't perfect

Finance isn't for perfectionists. Whether it's a price-to-earnings multiple, net income, or book value, no single metric can tell you about a business' quality or its investment prospects. 

Book value is best viewed as a "quick and dirty" way to score value creation at Berkshire, as even Buffett admits it has its weaknesses. Buffett often talks about how Geico is worth far more today than it was when Berkshire bought it in the 1990s, but the insurance company is carried on the balance sheet at a value that mostly reflects its historical cost rather than its present value. Geico's value has grown faster than its retained earnings, so its contribution to Berkshire isn't fully reflected on the balance sheet.

As time goes on and Berkshire continues its shift from a minority investor in public companies to a majority owner of operating businesses, book value will be less valuable as a measuring stick. But the day when book value loses any and all usefulness is probably years or even decades away.