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Part II: Buffett’s 2018 Letter to Berkshire Shareholders

publication date: Feb 25, 2019
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author/source: Brian Nelson, CFA

Part I of this multi-part series focused on Warren Buffett’s transition away from what we consider arbitrary book value and how the Oracle of Omaha thinks about share buybacks. Let’s dig further into his letter in Part II.

<< Read Part I

By Brian Nelson, CFA

It was a long time coming but Warren Buffett has finally done away with book value as a measure of business performance (see Part I), and while we think there’s more to assessing a company than just looking at its market price of course, when it comes to operating entities, assessing intrinsic value, of which the market price is one estimate, remains a critical function of any discerning analyst. Book value, in any case, deserves to be “abandoned.”

From Buffett’s 2018 Letter to Berkshire Shareholders, released February 23:

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.

Another interesting component of Buffett’s 2018 recap was his mention of stiff competition in the private equity ranks with respect to identifying undervalued ideas. These days, the Oracle seems to find it easier to purchase smaller parts of larger companies than taking such companies completely in-house (and paying a premium). Berkshire's latest large purchase was years ago in one of our favorites, aerospace giant Precision Castparts.

That said, we think there’s plenty of room for savvy enterprise-value-oriented investors to take undervalued companies private. In my book Value Trap: Theory of Universal Valuation, I talk extensively about the outperformance of private equity versus other asset classes. An elephant-sized purchase may still be in the cards for the Oracle of Omaha, even if he may not get the price he wants.

It was good to read Buffett harp on EBITDA (earnings before interest taxes depreciation and amortization). His words:

When we say “earned,” moreover, we are describing what remains after all income taxes, interest payments, managerial compensation (whether cash or stock-based), restructuring expenses, depreciation, amortization and home-office overhead...That brand of earnings is a far cry from that frequently touted by Wall Street bankers and corporate CEOs. Too often, their presentations feature “adjusted EBITDA,” a measure that redefines “earnings” to exclude a variety of all-too-real costs.

Those that know Valuentum know that we don’t like taking short-cuts at all, whether it be the P/E ratio or EV/EBITDA or other valuation metrics, save for the price-to-fair value (P/FV) ratio (which is the only actual measure of price versus value). In Value Trap, I make the plea to retire the midstream metric distributable cash flow, and I was recently quoted in an article from S&P Global that shows how imbalanced distributable cash flow is relative to traditional free cash flow, which is measured as cash flow from operations less all capital expenditures.

Here’s my quote from S&P Global, “Enterprise’s shift on cash flow reflects ‘metamorphosis' of US pipeline firms:”

"The marketplace ... was ignoring the concept that growth capital associated with driving future distributable cash flow is also shareholder capital," Brian Nelson, president of investment research firm Valuentum Securities Inc., wrote in a September 2018 note to clients. "It becomes questionable whether distributable cash flow, because it does not deduct for growth capital spending, is a useful measure at all."

There's also a great graphic in that article.

We couldn’t help but mention the Oracle’s reference to Abraham Lincoln in his 2018 Letter, too: “'If you call a dog’s tail a leg, how many legs does it have?’ and then answered his own query: ‘Four, because calling a tail a leg doesn’t make it one.’ Abe would have felt lonely on Wall Street.”

Brian here. How awesome is that quote? It is as applicable to quantitative applications as there ever was a saying. Just because a field of study calls something “value” does not make it so. That’s the challenge we are facing in quantitative value today. What they are measuring just isn't value. Let’s pause here for now. There's much more to go as we continue to digest Warren Buffett’s 2018 Letter to Shareholders. 

Stay tuned and thank you!

Read Part III >>

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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.


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