On February 22nd Warren Buffett released his 2019 Letter to Shareholders, and as always, it was filled with timeless information. The following summarizes the three most important lessons we took away from this last year’s letter.

Real World vs. Accounting-Land

In 2018, a new accounting policy was adopted that requires companies who own stakes in marketable securities to account for any unrealized gains or losses in the income account, a rule that can only be described as lunacy.

What this policy means is that if a company decides to purchase $1 million worth of stocks and by the end of the year those stocks have grown to a value of $1.2 million, the company will record an extra $200,000 in income, even though they haven’t sold the securities and realized an actual gain.

This kind of accounting completely distorts the income statement of a corporation and makes their bottom line a few notches below useless. The numbers below show how absurd this accounting can make a company’s GAAP earnings look compared to the actual operating earnings of the business. The first line shows the Operating Income of Berkshire Hathaway, and the second line shows the GAAP earnings.

Operating Earnings:

2017 = $18,696

2018 = $28,623

2019 = $28,913

GAAP Earnings:

2017 = $44,940

2018 = $4,021

2019 = $81,417

This shows just how distorted earnings figures can become after applying the new GAAP rules. As Warren Buffett frequently says, accounting is the beginning of the financial analysis, not the end.

The Importance of Retained Earnings

The ultimate decision for investors over the past 100 years has been the decision between fixed income securities such as bonds and equity ownership in businesses via common stocks.

While both can produce an income stream through either dividends or interest payments, there remains a primary factor in deciding between these two investments. With the purchase of common stock, an investor gets the additional benefit of retained earnings that the company can pour back into the business to earn higher amounts of money, introducing a compound interest element into the ownership in common stocks.

Fixed-income security, on the other hand, such as a bond, has no element of compound interest. Instead, it pays out a fixed amount every year, and the investor then runs the risk of not investing that money at similar rates.

To further explain, let us look at an example. Imagine a business owner purchases a company for $1,000,000, and that company can consistently earn 20% on the business owner’s equity (assuming there is no debt). The result of this is that the business owner will receive a $200,000 return on his $1,000,000 investment, and if he continues this process, he will receive $200,000 every year that he owns the company. This represents a simple interest formula.

Let us imagine that instead of paying out the full $200,000 profit to the owner, that money is kept within the business to help it grow. In the second year, the company once again earns 20% on the owner’s equity. However, because the owner reinvested the $200,000 profit from the previous year, the business is earning 20% on $1.2 million rather than $1 million, resulting in a higher yield of $240,000. If this exact process is repeated, the business owner’s profits will be $288,000 in the third year, $345,600 in the fourth year, and $414,720 in the fifth year, all because the owner decided to retain the earnings of the business rather than pay it out. This represents a compound interest formula.

This is the all-important factor that separates stocks from bonds.

Three Criteria for Purchasing a Company

In the majority of his annual letters, particularly his earlier ones, Warren Buffett sets out three criteria that he looks for when purchasing a company:

1. The business must earn good returns on net tangible capital required in their business.
2. The business must be run by honest and able managers.
3. The business must be available at a reasonable price.

While his criteria are straightforward, it may help to delve deeper into each one.

1. The business must earn good returns on the net tangible capital required in their business.

When a business invests in certain assets, whether that is machinery, equipment, or land, they must see a return on the money they are spending. If an airliner spends $100 million on an airplane and the most they can earn from that plane is a 2% profit (something airplanes tend to do), that would be a deplorable use of money.

On the other hand, if a company builds a new clothing store and earns a 20% profit on the store year after year, that would prove wise use of capital. Buffett is simply saying he wants a company that will give him a good return on his investment.

2. The business must be run by honest and able managers

No investment course or finance textbook will cover the importance of having quality managers involved in the business you invest in, but few things could be as important. Regardless of how profitable the business is or how exciting its products can be, these factors will cease to be necessary if its managers lack integrity (as I’m sure the former employees of Enron would be happy to attest.)

3. The business must be available at a sensible price

Warren Buffett’s attribute is best known for is his ability to wait to purchase a business until he can get it for a reasonably attractive price. While a vast portion of finance “professionals” think he has some magic formula to valuing a company, his formula was clearly laid out in his writing of The Economic Principles of Berkshire Hathaway:

“The value of a company is the discounted value of all the cash that can be taken out of the business during its remaining life.”

Therefore, the job of an investor is to estimate the cash that the business will pay out during its remaining life and discount that number back to present-day terms using the going rate of secure government bonds. While the value an investor comes up with will never be 100% accurate, it will help determine a sensible price to pay for the business.

These three criteria are something that all managers and investors should consider before they purchase any business, whether they are purchasing shares in the company or purchasing the entire industry. While Warren Buffett has yet to write a book, and perhaps never will, the lessons that can be learned from his annual letters over the years provide more knowledge than any book could possibly offer.

Anyone interested in learning about investments or business, in general, would be doing themselves a disservice if they did not take the time to read each of Warren Buffett’s letters and absorb the invaluable information contained in them.

This article has been reprinted with permission from William Douthat’s Linkedin page.