Arguing with Warren Buffett, Play-Doh, and Business Valuations
I rarely argue with my wife.
She’s right 99% of the time, so there’s no need to argue.
Now, I used to. About every 85th or 87th time, I’d argue just so I could be right at least ONCE.
I found it to be waste of time- why bother?
Which brings us to Warren Buffett.
Two Billionaires
At 93, Buffett is one of the most successful investors in history. His Wiki bio:
“Co-founder, chairman and CEO of Berkshire Hathaway. As a result of his immense investment success, Buffett is one of the best-known investors in the world. As of December 2023, he had a net worth of $120 billion, making him the ninth-richest person in the world.”
Jimmy Haslam, another billionaire, is in a dispute with Warren Buffett over a business valuation.
The Dispute
Have you ever stopped at a Pilot Flying J truck stop off of a highway?
Well, Jimmy Haslam has already sold 80% of Pilot Flying J to Berkshire Hathaway for $11 billion. Berkshire Hathaway is a holding company for Buffett’s investments (they didn’t invest much in the website, however…).
Now Buffett is buying the remaining 20% of Pilot Flying J from Haslam, and the value of that remaining 20% is in dispute.
So, what is the business worth? Here are some factors that make a business valuable:
Brand awareness: Apple is one of the most recognized brands in the world, and that creates value. I’ll always buy a MacBook or iPhone- I’m not switching brands.
Stable customer base: Grocery stores sell us the same products over and over. Repeat business is valuable, because you don’t have to spend marketing dollars on finding that customer- he or she just keeps showing up.
Disruption: Uber and Lyft disrupted the taxi business. It may take years to generate a profit, but they each have a large share of the market.
The most common accounting metric to value a business may be earnings per share.
Earnings per Share: The Play-Doh Analogy
Did you have a Play-Doh machine as a kid?
You put the dough in the toy, turn the handle, and the dough comes out in the different shapes on the other end.
That’s like generating company earnings. In this context, earnings is the same as net income.
The dough you put in is material, labor costs to make a product or service. Turning the handle is creating the customer product, and the dough that comes out is the profit (earnings) after you make a sale.
Earnings per share is defined as (net income divided by common stock shares outstanding).
Arguing About Earnings
According to Pro Football Talk:
“The litigation centers on allegations by Haslam that Buffett is trying to do things to drive down the value. Buffett, in turn, claims that Haslam is trying to do things to increase the value.
That resulted in a recent allegation by Buffett that Haslam tried to bribe Pilot executives to inflate profits and, in turn, to increase the company’s value. Pilot has dismissed that allegation as ‘strategic inventions’ and a ‘wild theory’.”
How can earnings be inflated?
Manipulating Earnings to Increase a Valuation
The formula for net income is revenue less expenses.
If you want to manipulate earnings, you falsify either revenue, expenses- or both.
Increasing revenue
Assume that a furniture manufacturer has an accounting policy that the business must recognize revenue when customer orders are shipped.
To boost earnings, the company post sales before orders are shipped. Maybe a group of orders are posted into December of 2023, but the orders aren’t shipped until early January of ’24.
Higher 2023 sales generate higher 2023 earnings.
Delaying expenses
The other side of the coin is not posting expenses until a later accounting period.
Generally speaking, expenses should be posted when incurred. When in doubt, post expenses immediately.
But…
You could delay posting a group of December 2023 expenses until January of ’24. 2023 expenses are lower, and net income is higher.
What prevents this type of manipulation from happening?
The principle of consistency
Businesses strive to apply accounting principles consistency from one period to the next. If principles are not consistency followed, it’s a red flag. If you have an external audit performed, the CPA firm conducting the audit will assess consistency.
The revenue or expense manipulation would likely be uncovered by an auditor. The CPA partner would request that the business post adjusting entries to correct the misstatements. If the client refuses, the CPA firm may not issue an unqualified audit opinion.
Stay tuned- who know where this will end up.