Investors look forward to Warren Buffett’s annual shareholder letter, and in the 2023 version, released on Feb. 24, he didn’t disappoint. It was chock-full of Buffett’s typical down-to-earth, blunt, and solid investing advice mixed with his wit and humor.
He paid tribute to his decades-long investing partner, Charlie Munger, who passed away last year, and in a first, he addressed the letter as if he were writing to his sister Bertie.
She’s a longtime Berkshire Hathaway (NYSE: BRK.A)(NYSE: BRK.B) shareholder whom Buffett described as understanding “many accounting terms, but … not ready for a CPA exam.” In doing so, he’s addressing the vast majority of individual investors.
In the letter, he points to Berkshire’s earnings numbers, which look strange when you consider how they have changed over the past three years. And he calls the net income metric “worse than useless.” Here’s how he counsels investors to use it when evaluating a company.
Net income vs. operating income
Buffett highlighted Berkshire Hathaway’s net income, in contrast with its operating income.
|
Metric |
2021 |
2022 |
2023 |
|---|---|---|---|
|
Net income (loss) |
$89.9 billion |
($22.8 billion) |
$96.2 billion |
|
Operating income |
$27.6 billion |
$30.9 billion |
$37.4 billion |
Data source: Berkshire Hathaway.
He noted how something looks off with the changes in net income, so even though a public company has fulfilled its legal duty by reporting “this worse-than-useless ‘net income’ figure” according to regulations, it makes him uncomfortable.
The main difference between the two figures is unrealized capital gains and losses, which refers to price changes for stocks Berkshire Hathaway owns. Individual investors don’t usually have to worry about unrealized capital gains or losses; gains or losses only come into play when they sell a stock, at which time there are capital gains tax considerations for the shareholder.
Since Berkshire Hathaway is a holding company that reports its equity positions as assets, unrealized capital gains or losses get recorded on its financial statements. And since they track publicly-traded companies, the value of these equity positions changes daily — as much as $5 billion per day. This can highly influence the total net income or loss reported for the quarter, even though it has little bearing on the company’s operations and little connection to long-term stock movements.
What should investors do with net income?
Calling net income “worse than useless” might be a bit of hyperbole to get his point across, since he follows it up by saying that it “should be a sensible concept that Bertie will find somewhat useful — but only as a starting point — in evaluating a business.”
It might be worse than useless if not taken in the right context, since it can create a false impression. But if used as a starting point to evaluate a business, it can provide insight into what’s actually going on at the company.
Notice he doesn’t say “in evaluating a stock.” Buffett has said he’s not a stock picker but a business picker. He recommends buying great businesses with strong management, an excellent product that can endure over time, and a competitive edge.
In the case of Berkshire Hathaway, you want to know what’s affecting its business, including its stock positions and how they’re doing at a given moment in time. But you don’t want that to be the only factor or the endpoint.
Pulling out the unrealized capital gains and losses from the equation gives you a better view into the daily operations of the business.
The whole picture
Net income is a popular metric because it’s the literal bottom line. Many companies use profitability metrics like earnings before interest, taxes, deprecation, and amortization (EBITDA) — or the very popular adjusted versions — to give shareholders a glimpse into their core operating activities. Buffett finds these metrics even more useless than net income, calling them “a banned measurement at Berkshire.”
Companies’ management teams often rely on these metrics to paint a bright picture, and a business can be reporting losses and negative cash flow while increasing EBITDA. But even EBITDA can add to an investor’s understanding of a business as yet another data point.
For example, if EBITDA is consistently increasing, and the margin is getting higher, stronger net profits (or as Buffett might prefer, operating profits) could be coming down the line. And such improvements could signal the right time to buy.
The danger is in relying too much on any of these metrics. Net income might be the right starting point for an analysis, but you want to understand all of a company’s financial statements, following them over time to see if an investment is worth your money.
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Jennifer Saibil has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.
Warren Buffett Calls This Metric “Worse Than Useless,” but Everyone Uses It. Here’s How to Make Yourself a Smarter Investor. was originally published by The Motley Fool
Source: finance.yahoo.com