Warren Buffett's 1986 Berkshire Hathaway Shareholder Letter: Why Book Value and Cash Flow Mislead Investors

In the 1986 shareholder letter, Warren Buffett, Chairman of the US-based Berkshire Hathaway Inc., delves into two key traps in measuring a company's true value: the limitations of book value and the misuse of 'cash flow' by Wall Street. This letter is not only an exposition of investment methodology but also a profound analysis of the economic substance behind accounting figures.

First, Buffett points out that for most companies, there is a significant difference between book value and intrinsic business value, with the latter being the number owners truly care about. Although Berkshire's own book value once served as a reasonable proxy for business value, the two are not identical. He specifically emphasizes that 'goodwill' created by excellent managers through improved profitability often does not appear in the net worth on the balance sheet. For example, the managers mentioned in the text, such as the Blumkin family and Mike Goldberg, significantly increased business profitability with almost no additional capital. This unrecorded gain constitutes real economic value, which may be masked by simple book growth. Therefore, investors should not just stare at the growth rate of book value per share, but should focus on the management capabilities that can generate sustained excess returns.

Secondly, Buffett severely criticizes the popular concept of 'cash flow' at that time. He believes that many investment banks and analysts add depreciation back to net profit to calculate cash flow, while ignoring the capital expenditures required to maintain competitiveness. He wrote in the letter: "If all American companies were sold simultaneously through our major investment banks—and believing the sales brochures describing them—the government's projections for national plant and equipment expenditures would be cut by 90%." This satire reveals the absurdity of ignoring maintenance capital expenditures. For enterprises in manufacturing, retail, etc., that require continuous reinvestment, so-called 'free cash flow' is meaningless if it does not deduct necessary update expenditures. Buffett advocates using the concept of 'Owner Earnings', which is net profit plus non-cash expenses such as depreciation, minus the average capital expenditure required to maintain current competitive position.