Warren Buffett: The Key Metrics for Business Evaluation

Johnny HopkinsWarren BuffettLeave a Comment

In his 1979 Berkshire Hathaway Annual Letter, Warren Buffett discussed Berkshire Hathaway’s 1979 operating performance, which was strong but slightly less impressive than in 1978, with operating earnings at 18.6% of beginning net worth.

Despite a 20% increase in earnings per share, Warren Buffett cautions against focusing on this metric. He argues that rising earnings per share can be misleading, as even passive investments show growth due to reinvested interest.

The true measure of managerial performance is a high return on equity capital without excessive leverage or accounting tricks. Buffett suggests that businesses and analysts should prioritize evaluating economic performance over year-to-year changes in earnings per share for a clearer understanding.

Here’s an excerpt from the letter:

On this basis, we had a reasonably good operating performance in 1979—but not quite as good as that of 1978—with operating earnings amounting to 18.6% of beginning net worth.  Earnings per share, of course, increased somewhat (about 20%) but we regard this as an improper figure upon which to focus.

We had substantially more capital to work with in 1979 than in 1978, and our performance in utilizing that capital fell short of the earlier year, even though per-share earnings rose.

“Earnings per share” will rise constantly on a dormant savings account or on a U.S. Savings Bond bearing a fixed rate of return simply because “earnings” (the stated interest rate) are continuously plowed back and added to the capital base.  Thus, even a “stopped clock” can look like a growth stock if the dividend payout ratio is low.

The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.

In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.

You can read the entire letter here:

1979 Berkshire Hathaway Annual Letter

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