| Warren Buffett's annual letter to Berkshire | | | | true economic changes to an owner's share of |
| Hathaway shareholders was released over the | | | | the business. There is no truly comprehensive |
| weekend. Readers will find plenty of investing | | | | income number - and there never will be. A |
| lessons among the twenty-three pages. Warren | | | | review of the financial statements alone is not |
| began this letter as he begins each letter, by | | | | sufficient to determine how a business' |
| stating Berkshire's change in per-share book value: | | | | competitive position has improved (or |
| "Our gain in net worth during 2005 was $5.6 billion, | | | | deteriorated) over the course of the year. |
| which increased the per-share book value of both | | | | "Every day, in countless ways, the competitive |
| our Class A and Class B stock by 6.4%. Over the | | | | position of each of our businesses grows either |
| last 41 years, (that is, since present management | | | | weaker or stronger. If we are delighting |
| took over) book value has grown from $19 to | | | | customers, eliminating unnecessary costs and |
| $59,377, a rate of 21.5% compounded annually." | | | | improving our products and services, we gain |
| Some may wonder why Buffett opens by | | | | strength. But if we treat customers with |
| announcing the change in per-share book value | | | | indifference or tolerate bloat, our businesses will |
| rather than the earnings per share number. Over | | | | wither. On a daily basis, the effects of our actions |
| long periods of time, the change in per-share book | | | | are imperceptible; cumulatively, though, their |
| value should nicely approximate the returns to | | | | consequences are enormous." |
| owners. You may remember that, in my analysis | | | | It is to these actions and their effects that an |
| of Energizer Holdings, I applauded the company | | | | investor must look when he is forming his |
| for reporting comprehensive income within the | | | | qualitative assessment of a business. After all, a |
| income statement. Although a company's net | | | | company may lose money and yet improve its |
| income is often referred to as its bottom line, net | | | | competitive position. In fact, that is exactly what |
| income is, in fact, a (sub)component of | | | | a great many young businesses do. The question, |
| comprehensive income. Energizer Holdings (ENR) | | | | of course, is whether those present losses will be |
| literally reports comprehensive income as its | | | | more than offset by future gains after accounting |
| bottom line. | | | | for the opportunity costs incurred. |
| FASB merely requires that "an enterprise shall | | | | All costs are opportunity costs. It makes no |
| display total comprehensive income and its | | | | sense to evaluate a year's losses as if the |
| components in a financial statement that is | | | | alternative was to stop time. The available returns |
| displayed with the same prominence as other | | | | on the lost capital must be considered as well. |
| financial statements that constitute a full set of | | | | That is why when one of Berkshire's units has |
| financial statements". Unfortunately, despite the | | | | consumed capital, the loss has weighed heavily on |
| lack of attention paid to it by investors, the | | | | Buffett. |
| statement of changes in stockholders' equity is | | | | Over Berkshire's history, the cost of any losses |
| considered "a financial statement that constitutes | | | | also included the over twenty percent compound |
| a full set of financial statements". | | | | annual gain that was foregone. Buffett has always |
| Therefore, comprehensive income can be | | | | been painfully aware of the fact that, for |
| reported in a statement many investors either do | | | | Berkshire, losing $1,000 today would be much the |
| not review or do not understand. Alternatively, a | | | | same as losing over $7,000 ten years from today |
| company may choose to report comprehensive | | | | or over $125,000 twenty-five years from today. |
| income in a separate Statement of | | | | Berkshire will no longer grow its per-share book |
| Comprehensive Income. This, of course, baffles | | | | value at over 20% a year. So, these particular |
| many investors, who think they are reading a | | | | figures are outdated. However, if you refer to |
| second copy of the income statement. After all, | | | | Buffett's thoughts at the time when the Buffalo |
| what is comprehensive income? Isn't the net | | | | News was losing money (and when Berkshire's |
| income number reported in a (traditional) income | | | | textile operations were losing money), you will see |
| statement a comprehensive number? | | | | just how heavily these opportunity costs weighed |
| No. The widely reported earnings per share | | | | on him. |
| number is not comprehensive. That isn't to say | | | | Still, it is possible that a business operating at a |
| the EPS number isn't important. It is very | | | | loss is actually improving its competitive position |
| important. In fact, for certain businesses, it may | | | | and creating wealth for its owners. One very |
| be the most useful figure for evaluating a going | | | | difficult question that must be answered is exactly |
| concern. This is especially true if the investor is | | | | what the assets (often the intangible assets) that |
| only looking at the financials for a single year. A | | | | have been gained at great expense are actually |
| single year's comprehensive income may actually | | | | worth. In some very special businesses, huge |
| be less representative of a business' performance | | | | expenses are fully justified. |
| than a single year's EPS number (both can be | | | | "Auto policies in force grew by 12.1% at GEICO, a |
| pretty unrepresentative).Remember, the earnings | | | | gain increasing its market share of (the) U.S. |
| per share number does not tell you how much | | | | private passenger auto business from about 5.6% |
| wealth was actually created (or destroyed). You | | | | to about 6.1%. Auto insurance is a big business: |
| need to look to the comprehensive income | | | | Each share-point equates to $1.6 billion in sales." |
| number to find that information. | | | | "While our brand strength is not quantifiable, I |
| Essentially, Buffett is reporting Berkshire's earnings | | | | believe it also grew significantly. When Berkshire |
| in that opening line. He is simply using a more | | | | acquired control of GEICO in 1996, its annual |
| comprehensive income figure. He's saying here's | | | | advertising expenditures were $31 million. Last |
| how much wealth we created, and here's how | | | | year we were up to $502 million. And I can't wait |
| much capital it took to create that wealth. When | | | | to spend more." |
| he writes "Our gain in net worth during 2006 was | | | | This excerpt helps explain why I think all the |
| $5.6 billion, which increased the per-share book | | | | money PetMed Express (PETS) puts into cable |
| value of both our Class A and Class B stock by | | | | TV ads is money well spent. Pet medications, like |
| 6.4%" he's really saying Berkshire earned $5.6 | | | | auto insurance, is a highly fragmented business. |
| billion and a 6.4% return on equity. He prefers | | | | Sales volume is important. Obviously, name |
| using comprehensive income rather than net | | | | recognition is as well. PETS can spend a lot on |
| income, because comprehensive income includes | | | | cable advertising and still spend less per sale than |
| non-operating earnings such as changes in the | | | | its competitors. It's also important to remember |
| market value of available for sale securities. | | | | that pet medications are rarely the sort of thing a |
| If you still have doubts about the idea that | | | | customer buys once (just like auto insurance). |
| Buffett is essentially reporting Berkshire's | | | | While you won't be able to retain all your |
| comprehensive income in that formulaic opening | | | | customers, you will have a much easier time |
| line of his annual letters, compare the change in | | | | getting a current customer to stick with you than |
| net worth numbers Buffett has reported in past | | | | you will getting a new customer to switch from a |
| years to the comprehensive income numbers | | | | competitor. |
| found in Berkshire's annual reports. For the past | | | | I'll end this post with one of Buffett's best lessons: |
| three years, Berkshire's reported "gain in net | | | | "Long ago, Sir Isaac Newton gave us three laws |
| worth" and Berkshire's reported "comprehensive | | | | of motion, which were the work of genius. But Sir |
| income" were $5.6 billion vs. $5.5 billion, $8.3 billion | | | | Isaac's talents didn't extend to investing: He lost a |
| vs. $8.2 billion, and $13.6 billion vs. $13.4 billion. I | | | | bundle in the South Sea Bubble, explaining later, "I |
| hope this helps explain why I like it when public | | | | can calculate the movement of the stars, but not |
| companies prominently report comprehensive | | | | the madness of men." If he had not been |
| income instead of presenting net income as if it | | | | traumatized by this loss, Sir Isaac might well have |
| were the Holy Grail of investing. | | | | gone on to discover the Fourth Law of Motion: |
| Of course, there is no such Grail. Neither net | | | | For investors as a whole, returns decrease as |
| income nor comprehensive income captures the | | | | motion increases. |