In the letter Buffett explained the decision by saying the metric had lost the relevance it once had.
Berkshire had «morphed» from a company whose assets were concentrated in marketable stocks into one whose major value resided in operating businesses, a reshaping he expected to continue.
The group’s equity investments are required to be valued at market prices but the operating businesses it owns are required by accounting standards to be valued at their book value, which he said was far below their «current value.»
With Berkshire likely to be a significant repurchaser of its shares over time (it bought back $US1.3 billion of its stock last year) it would be buying stock at prices above book value but below his estimates of intrinsic value.
That reference to intrinsic value is central to the decision to stop using book value as the reference point for value creation.
Buffett has described book value as a «crude but useful» tracking device for the number that he believes really matters, intrinsic value. He’s never provided that latter number, or explained precisely how he arrives at his estimates. Unlike book value, it is a subjective evaluation, one presumably based on the capitalisation of estimates of future cash flows.
When Buffett started investing back in the 1960s, book values for companies whose balance sheets were dominated by physical, tangible assets were a better guide to the realisable value of a company than they are today, when intangibles like brands values and intellectual property have become drivers.
The post-2008 environment, where markets have been awash with cheap central bank liquidity and risk asset values have soared, has seen the gaps between book values and market values become gulfs.
It has been an era for growth-style investors, rather than the Buffett-like value investors, one that may continue given the obvious central bank sensitivity — seen in the way the US Federal Reserve responded to last year’s sharemarket implosion by freezing plans to continue raising US interest rates — to unsettling financial markets.
The change doesn’t mean, however, that Buffett has abandoned his investing principles. While the market price he will use in future might be more volatile, in the long-term (rather than on a day-to-day or year-to-year) basis, it has tended to produce similar results to the old book value metric.
Between 1965 and 2018 the annual percentage increase in Berkshire’s book value per share was 18.7 per cent. Over the same period the gain in its share price was 20.5 per cent.
With Buffett believing the intrinsic value of Berkshire shares is higher than their market value, the shift will also help avoid outcomes that would otherwise produce performance numbers that he believes would be misleading.
With an increasing amount of its shareholders funds invested in operating companies, when it buys back its own shares at less than his estimated intrinsic value, the book value falls even as the intrinsic value rises.
«That combination causes the book-value scorecard to become increasingly out of touch with economic reality,» he wrote.
At December 31, Berkshire had a book value per share of $US212,503. Its share price is $US302,500, creating a gap of about $US123 billion between book and market values.
It’s little wonder that Buffett prefers the market price over book value as a guide to his value-creation. It’s also obvious that he wouldn’t be buying back stock at those sorts of premiums over book value if the old metric were retained.
The change in benchmarks does reflect changes in the nature of Berkshire and the way its investments and subsidiaries are accounted for. Whether it also reflects a change in investing philosophy from the most influential of value investors is a different issue; one that will only become apparent over time.
Stephen is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.