1999

Click here to read the letter.

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🧠 Key Takeaways

• While accounting isn’t perfect, some of these things—like depreciation, bad debt expenses, and inventory write-downs—are important estimates that quantify things actually happening in a business.

• When a company acquires another business, it’s usually buying it at a premium—and the spread between the business’s actual fair value and the purchase price is called goodwill. Warren thinks companies should record that goodwill on the balance sheet, leave it alone, and only write it down if the acquired business actually loses value.

• Be skeptical of stock-based deals. Just because they don’t involve cash doesn’t mean they’re low risk—especially if management is more focused on short-term optics than long-term economics.

• At some point, the stock market will take a hit—and when it does, better buying opportunities will be there. The thing is, not a single person knows when that will happen. And if some so-called expert tells you they can predict the when, why, or how of the next crash, that’s your cue to run away—fast.

• There are only two conditions that need to be met for share repurchases to make sense. First, the business must have excess capital that isn’t already committed to other, more immediate needs. And second, the stock must be trading at a discount to its intrinsic value.

• If a stock is trading below its intrinsic value, then buybacks make sense. If it’s not, then it doesn’t—regardless of whether shares were issued for stock options or anything else.

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✍️ Memorable Quotes

“Most accounting charges relate to what’s going on, even if they don’t precisely measure it. As an example, depreciation charges can’t with precision calibrate the decline in value that physical assets suffer, but these charges do at least describe something that is truly occurring: Physical assets invariably deteriorate. Correspondingly, obsolescence charges for inventories, bad debt charges for receivables and accruals for warranties are among the charges that reflect true costs. The annual charges for these expenses can’t be exactly measured, but the necessity for estimating them is obvious.”

While accounting isn’t perfect, some of these things—like depreciation, bad debt expenses, and inventory write-downs—are important estimates that quantify things actually happening in a business.

Assets will wear out. Customers won’t always pay. And products can lose value over time. The exact dollar amounts might be hard to pin down, but these estimates still matter, and they tell you a lot about the underlying economics of the business.

“Charlie and I believe there’s a reality-based approach that should both satisfy the FASB, which correctly wishes to record a purchase, and meet the objections of managements to nonsensical charges for diminution of goodwill. We would first have the acquiring company record its purchase price — whether paid in stock or cash — at fair value. In most cases, this procedure would create a large asset representing economic goodwill. We would then leave this asset on the books, not requiring its amortization. Later, if the economic goodwill became impaired, as it sometimes would, it would be written down just as would any other asset judged to be impaired. If our proposed rule were to be adopted, it should be applied retroactively so that acquisition accounting would be consistent throughout America — a far cry from what exists today. One prediction: If this plan were to take effect, managements would structure acquisitions more sensibly, deciding whether to use cash or stock based on the real consequences for their shareholders rather than on the unreal consequences for their reported earnings.”

When a company acquires another business, it’s usually buying it at a premium—and the spread between the business’s actual fair value and the purchase price is called goodwill. Warren thinks companies should record that goodwill on the balance sheet, leave it alone, and only write it down if the acquired business actually loses value.

Right now, though, the rules often force companies to amortize goodwill over time—even if nothing's really changed. That can lead to weird incentives where management structures deals just to make the accounting look better, not because it’s best for shareholders.

“From the economic standpoint of the acquiring company, the worst deal of all is a stock-for-stock acquisition. Here, a huge price is often paid without there being any step-up in the tax basis of either the stock of the acquiree or its assets. If the acquired entity is subsequently sold, its owner may owe a large capital gains tax (at a 35% or greater rate), even though the sale may truly be producing a major economic loss.”

On the surface, stock-for-stock deals might look clean—no cash changes hands, and no new debt is taken on—but from a tax perspective, there may be more to the story.

When a company is acquired using stock, the acquirer doesn’t get to reset the value of the assets it just bought for tax purposes. In other words, there is no “step-up” in the tax basis.

So later, if the acquirer decides to sell that business, the IRS might treat it as if the assets were still worth what the acquirer originally paid for them—however many years ago. That means the acquiring company could owe a huge capital gains tax, even if it actually lost money on the sale.

As an example, let’s say Company A acquires Company B in a stock-for-stock deal.

Company B owns assets that were originally bought for $100 million, and the fair market value of those assets at the time of acquisition is $300 million. Company A pays that full $300 million, but because it bought Company B using stock, it doesn’t get to reset the tax basis of those assets.

The IRS still sees them as being worth just $100 million on paper for tax purposes.

Now let’s say that, a few years later, Company A decides to sell Company B for $250 million. That’s a real loss—they paid $300 million, and they’re only getting $250 million back.

Because Company B was bought using stock, the IRS still sees its assets as being worth $100 million because that’s their original tax basis. So the IRS calculates a gain of $150 million ($250M sale price – $100M tax basis) and taxes Company A on that amount—even though it actually lost $50 million in reality.

Because of a situation like that, Warren is saying to be skeptical of stock-based deals. Just because they don’t involve cash doesn’t mean they’re low risk—especially if management is more focused on short-term optics than long-term economics.

“Berkshire will someday have opportunities to deploy major amounts of cash in equity markets — we are confident of that. But, as the song goes, “Who knows where or when?” Meanwhile, if anyone starts explaining to you what is going on in the truly manic portions of this “enchanted” market, you might remember still another line of song: ‘Fools give you reasons, wise men never try.’”

This one’s pretty straightforward: at some point, the stock market will take a hit—and when it does, better buying opportunities will be there.

The thing is, not a single person knows when that will happen. And if some so-called expert tells you they can predict the when, why, or how of the next crash, that’s your cue to run away—fast.

“There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated.”

Simply put, there are only two conditions that need to be met for share repurchases to make sense. First, the business must have excess capital that isn’t already committed to other, more immediate needs. And second, the stock must be trading at a discount to its intrinsic value.

“Rationally, a company’s decision to repurchase shares or to issue them should stand on its own feet. Just because stock has been issued to satisfy options — or for any other reason — does not mean that stock should be repurchased at a price above intrinsic value. Correspondingly, a stock that sells well below intrinsic value should be repurchased whether or not stock has previously been issued (or may be because of outstanding options).”

A lot of companies repurchase shares just to offset those issued for employee stock options. That’s pretty common in the market.

But Warren doesn’t agree with that logic. In his opinion, buybacks should stand on their own merits—stock option dilution isn’t a good enough reason.

At the end of the day, if the stock is trading below its intrinsic value, then buybacks make sense. If it’s not, then it doesn’t—regardless of whether shares were issued for stock options or anything else.

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