Lesson 7 of 8
How long the price assumes
The 1991 Berkshire letter values one million dollars of earnings at 25 million on one assumption and 10 million on another. The difference is entirely duration.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Value creation has two dimensions: how much a company earns above its cost of capital, and how long it goes on doing so. The second is called the competitive advantage period.
- The 1991 Berkshire letter works the arithmetic in public: the same one million dollars of after-tax earnings is worth 25 million on a growing perpetuity and 10 million with no growth.
- A multiple is therefore a duration assumption in disguise, and the useful exercise is solving for the duration rather than arguing about the multiple.
Mauboussin, Callahan and Majd call duration the second dimension of sustainable value creation and note that it receives less attention than its importance warrants. It is also, in most valuations, the assumption nobody writes down.
The same earnings, two durability assumptions
- Earnings growing 6% a year forever, no extra capital, discounted at 10%$25m
- The same earnings as normal earning power, bobbing around, discounted at 10%$10m
The letter's own arithmetic
The 1991 letter sets out what it calls simplified but relevant math. Suppose a property earns one million dollars after tax, grows that at 6 percent a year without needing additional capital, and is discounted at 10 percent. It is appropriate to pay 25 million dollars for it, an after-tax multiplier of 25, which the letter says translates to about 16 times pre-tax earnings.
Now change one assumption. Treat the same one million dollars as normal earning power that will bob around cyclically rather than grow, discount it at the same 10 percent, and the valuation is 10 million dollars, or about 6.5 times pre-tax earnings.
The letter's conclusion is the one to carry: a seemingly modest shift in assumptions changes the valuation dramatically, and what had caused buyers to pay far more for a dollar of media earnings than a dollar of steel earnings was the expectation of growth without additional capital.
Why this is the duration question
The growing case is not really a growth assumption. It is a durability assumption: that nothing arrives to compete the growth away, for ever. The bob-around case assumes the opposite from day one.
Any multiple between the two is an implied number of years of excess return. That is the competitive advantage period, and solving for it is more useful than arguing about the multiple, because the years can be checked against what the industry's history shows.
Solving for the years
Take the value the market is paying, subtract the value of the business with no excess return at all, and the remainder is what is being paid for the advantage. Then ask how many years of the current excess return that remainder represents.
The answer is a number a person can be held to. Twelve years of excess return in an industry where no participant has held an advantage for more than six is a claim, and it is now a claim in a unit that can be argued with.
Why no price appears in this lesson
A duration solved from a current price is true on the day the price was observed and false afterwards. Every figure in this academy that depends on a price would date the page it sits on, so the arithmetic here is shown on invented round inputs and on a published example from 1991 whose numbers were printed by their author.
The method is the transferable part. The price is the reader's to supply on the day they use it.
Check yourself
In the 1991 letter's arithmetic, what is one million dollars of after-tax earnings worth on each assumption?
- 25 million on both
- 25 million growing at 6 percent a year without extra capital, and 10 million as normal earning power with no growth, both discounted at 10 percent
- 16 million and 6.5 million
Show the answer
Answer: B.
The 16 and 6.5 figures in the letter are the equivalent pre-tax multiples. The after-tax multiples are 25 and 10.What is a multiple, read as this lesson reads it?
- A measure of how profitable a company is
- A duration assumption: the number of years of excess return being paid for
- A measure of risk
Show the answer
Answer: B.
The gap between the value paid and the value of the same business with no excess return is what is being paid for the advantage, and it converts into years.Why does this lesson use invented inputs rather than a current price?
- Because prices are not available
- Because a duration solved from a price is true only on the day the price was observed
- Because the method does not work on real companies
Show the answer
Answer: B.
The method transfers; the price does not. A page carrying a solved duration would be stale the week after it was written.Sources
- Berkshire Hathaway shareholder letter, 1991: the valuation math for a media property under a growing perpetuity and under normal earning power, and the conclusion that a modest shift in assumptions changes the valuation dramatically.
- Mauboussin, Callahan and Majd, Measuring the Moat, Credit Suisse, 1 November 2016: the two dimensions of sustainable value creation, and duration under the names fade rate and competitive advantage period.
What this leaves out
- The 1991 figures are the letter's own simplified example, described there as over-simplified but relevant. They are not a valuation of anything.
- The years-of-excess-return table is undiscounted, which makes it a rough unit rather than a precise one, and it uses invented round inputs.
- No price appears anywhere in this lesson, so nothing in it can be read as a view on what any security is worth.