Warren Buffett tends to be an upbeat kind of guy. And it's not just because he has amassed one of the greatest fortunes in the world. He's always been that way.
However, the legendary investor was decidedly gloomy in one part of his latest letter to Berkshire Hathaway (BRK.A -0.34%) (BRK.B -0.96%) shareholders. You might even say that he sounded like an Old Testament prophet. Buffett issued a warning that every investor should heed.
Image source: The Motley Fool.
Don't be deceived
In case you think I'm being overly dramatic, Buffett specifically stated that he was giving what he called "an important warning." After briefly referencing Berkshire Hathaway's results for 2022 detailed in its 10-K filing, he cautioned against trusting companies' operating earnings figures.
Why would Buffett urge investors to be wary of earnings numbers? He wrote that the figures "can easily be manipulated by managers who wish to do so."
Buffett also explained why companies' management teams could be tempted to cook the books. He noted that some CEOs and board directors view engineering positive earnings results as "sophisticated." Even worse, Buffett said that some reporters and Wall Street analysts not only embrace the practice but also cheer beating expectations as "a managerial triumph."
As you might expect, Buffett doesn't agree with those takes one bit. He didn't mince words in his comments, writing:
That activity is disgusting. It requires no talent to manipulate numbers: Only a deep desire to deceive is required. "Bold imaginative accounting," as a CEO once described his deception to me, has become one of the shames of capitalism.
Why Buffett's warning matters -- a lot
A little later in Buffett's letter to Berkshire shareholders, he listed several quotes from his longtime business partner, Charlie Munger. One of those timeless investing lessons from Munger was, "If you don't see the world the way it is, it's like judging something through a distorted lens." That sums up the worst problem for investors with relying too heavily on earnings figures. When the numbers are manipulated, you're seeing the business through a distorted lens.
Buffett's warning matters -- a lot -- because earnings are emphasized so much by Wall Street and investors as a whole. Every quarter, stocks rise and fall based on how their earnings compared to what analysts were expecting.
The most commonly used valuation metrics focus on earnings as well. Whether we're talking about the price-to-earnings (P/E) multiple or the price-to-earnings-to-growth (PEG) ratio, companies' earnings numbers are the most important number.
Buffett and Munger place a lot of weight on earnings, too. Buffett wrote in the letter that operating earnings is the "figure that we favor." In discussing Berkshire Hathaway's 2022 performance, the first metric he cited was the company's record earnings of $30.8 billion.
By the way, Buffett wasn't warning about adjusted earnings -- the numbers companies sometimes use to factor out large non-recurring revenue and expenses. He stated unequivocally that the operating earnings figures he was referring to are those calculated using generally accepted accounting principles (GAAP).
Not every company's management manipulates earnings, of course. But even when that isn't the case, Buffett's caution still stands. In discussing Berkshire's own quarterly earnings in 2022, he stated, "The GAAP earnings are 100% misleading when viewed quarterly or even annually." He added that the "quarter-by-quarter gyrations, regularly and mindlessly headlined by media, totally misinform investors."
What can investors do?
When one of the greatest investors of all time says not to trust earnings results, what can investors do? Buffett hinted at one answer in his letter: You can look at earnings trends over multiple years.
There's also another metric that isn't so easy to manipulate that can give you a better picture of profitability than earnings. Free cash flow is the amount of cash a business has left over after covering its operating costs and making capital expenditures on assets such as buildings, property, and equipment.
Buffett knows that his warning won't prevent unscrupulous management from reporting deceiving results. He also knows that most analysts and investors will continue relying on numbers that might not reveal how a business is actually performing. But investors who heed his advice will be able to make smarter decisions about the stocks they buy.
