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Beyond Book Value: Buffett's Approach to Measuring True Business Worth

By sagebytes —

Warren Buffett's Investment Best Practices

Distilled from the 2001 Berkshire Hathaway Annual Letter

Core Investment Principles

  1. Focus on intrinsic value, not market fluctuations
    • Book value is a useful metric but intrinsic value is the true measure of a business's worth
    • Long-term investors should measure performance against general market experiences (Buffett uses S&P 500)
    • Small advantages annually over the index will prove rewarding over time
  2. Maintain strict underwriting discipline
    • Only accept risks you can properly evaluate (stay within your circle of competence)
    • Limit business accepted to avoid concentration of losses from a single event
    • Avoid moral risk (contracts with unethical partners)
    • Factor in exposure, not just experience - consider worst-case scenarios
  3. Economic reality trumps accounting measurements
    • Accounting conventions often obscure business reality
    • Be wary of misleading metrics like "EBITDA" and "pro forma" results
    • Accounting is sometimes "self-graded" - be conservative in your own assessments
  4. Float management is critical
    • "Float" is money you hold but don't own - it can be a valuable asset
    • Focus on both the amount of float and its cost
    • A business creates value when its cost of float is less than market rates
  5. Avoid excessive debt
    • "Debt is a four-letter word around Berkshire"
    • Maintain financial strength to weather crises and capitalize on opportunities

Acquisition Strategy

  1. Look for businesses with excellent economics
    • Favor companies with "economic characteristics ranging from good to superb"
    • Strong businesses run by smart, seasoned, and trustworthy managers create lasting value
  2. Focus on quality of leadership
    • "Star-studded" managers are invaluable assets
    • Look for leaders with high-grade, entrepreneurial attitudes who think like owners
    • True ownership means managers face both upside and downside of decisions
  3. Pay with cash when possible
    • Cash acquisitions allow shareholders to retain full ownership in existing businesses

Market Outlook & Expectations Management

  1. Realistic expectations about returns
    • Equity prices presage only moderate returns after periods of outperformance
    • A market that merely parallels business progress may disappoint investors
    • Size limits opportunities - "We need elephants to make significant gains now and they are hard to find"
  2. Patience and discipline in allocations
    • Make few portfolio changes - hold excellent businesses for the long term
    • Be willing to act decisively on rare opportunities (like distressed debt)
    • Purchase securities only at reasonable valuations
  3. Integrity and alignment with shareholders
    • Managers should have significant skin in the game
    • Economic results for managers should parallel those of shareholders
    • Avoid companies where CEOs view shareholders as "patsies, not partners"