Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy
Posted in Accounting, Berkshire Annual Letter on Jun 18th, 2006
This comes from the appendix of the 1986 letter. Looking at the accounts, which company do you think is more valuable?
| Company O | Company N |
In case you haven’t realised, companies O and N are the same company – Scott Fetzer. The O column shows what the company’s 1986 GAAP earnings would have been if Berkshire had not purchased it. The N column shows the restated earnings.
In both statements, you are actually looking at exactly the same company. The difference came about because Scott Fetzer was purchased at a price above its stated net worth. Under GAPP, same a premium must be accounted for by “purchase-price adjustments” on the balance sheet.
Without going into details, this was done by adjustments to inventory costs, assets and liabilities with the balance going into Goodwill.
| Company O | Company N |
Because of the higher asset valuation, the depreciation every year will be higher. Combined with the amortization of Goodwill, the reported earnings for subsequent years will be lower.
If you value a business based on a certain multiple of earnings, what does all these mean to you? Does it make sense that a company would be worth significantly less the day after it was acquired?
A correct valuation of the “owner earnings” of a company should be based on (a) reported earnings plus (b) depreciation, depletion, amortization and certain other non-cash charges minus (c) average annual amount of capitalised plant and equipment that the business needs to fully maintain its long term competitive advantage and its unit volume.
Using such a method, you will be able to derive the same owner earnings for both company O and N.
Care must be taken in depending too much on the “cash flow” numbers. These numbers include (a) and (b) but do not substract (c). This number is meaningless for business such as manufacturing, retailing, utilities, because for them, (c) is significant.
A company may be able to defer spending in any given year, but over a 5 or 10 year period, they must make the capital investment.
Remember that accounting is but an aid to business thinking, never a substitute for it.
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