Each year for nearly half a century, Berkshire Hathaway (NYSE:BRK.B) has provided an annual letter to shareholders that discusses the gains it has produced for holders of its common stock. In 2012, according to its letter, that gain was $24.1 billion. Some $1.3 billion of that gain was used to repurchase Berkshire shares, leaving a $22.8 billion “increase in net worth” that the company retained. Over nearly 50 years, the company's shareholders’ equity, or book value, has grown almost 20% annually. Below, we discuss how analyzing shareholders' or owners’ equity is among the most important exercises for investors and shareholders.
What Do the Major Owners’ Equity Sections Tell an Investor?
Berkshire Hathaway’s book value growth over time has been relatively easy to measure. This figure is relatively clean, because Chief Executive Warren Buffett rarely buys back stock or issues additional shares, and he has never paid a dividend. For this reason, its growth in book value is a relatively good gauge for the returns shareholders have earned over the company’s history. At the end of 2012, the company's total shareholders’ equity grew to $191.6 billion and consisted primarily of retained earnings, which grew to $124.3 billion and is simply the earnings that have been reinvested back into the business over the years.
Berkshire Hathaway’s Shareholders’ Equity Section - 2012:
Looking at the equity section table above, analysts need to become familiar with some line items:
- Common stock has been steady at $8 million and represents the likely amount originally issued when the current incarnation of Berkshire Hathaway was formed in 1977. This par value amount of $8 million is primarily for legal and issuance purposes and is set at a very low initial value that is initially recorded on the books.
- The capital in excess of par value is also known as paid-in capital, which represents the premium over stated par value (the $8 million) at which the original shares were issued. In the literal sense, it truly represents the capital “paid in” by early-round investors, or capital contributed by owners. This comes primarily in the form of common stock but can also include other related securities such as preference shares or preferred stock. It also changes over time as new shares are issued, such as for acquiring interests in other businesses.
- Accumulated other comprehensive income (AOCI) is worthy of its own analysis and is a very insightful line item that is best seen as a more expansive view of reported net income on the profit and loss statement. It represents net income plus other comprehensive income, which covers items that don’t flow directly through the income statement. For instance, for financial firms such as Berkshire that own large insurance operations, AOCI gives details on unrealized gains and losses in the investment portfolio. The impact of corporate retirement plans is also covered in this section, as well as foreign currency fluctuations. For Berkshire, AOCI was $27.5 billion in 2012, or more than 14% of shareholders’ equity.
- Treasury stock reflects the shares of a company that it has bought back or repurchased from secondary markets. For this reason, it is also known as a contra account because it reduces reported owners’ equity. As we mentioned, Berkshire doesn’t buy back its own stock often, but it has to the tune of $1.4 billion over its history.
- The final category in its owners' equity statement is noncontrolling interests, which represents Berkshire’s ownership in other companies where it doesn’t have a controlling interest. However, they have value and are a key component of book value.
Statement of Changes in Owners' Equity
Another insightful financial statement that is not relied on enough is that of changes in owners' equity. As the name implies, it lets shareholders look at how owners’ equity has changed over time. For Berkshire, its 2012 statement goes back three years. It says Berkshire issued common shares that increased paid-in capital, that AOCI grew by more than $10 billion because of investment appreciation, and retained earnings increased as profits were retained. Treasury stock was purchased over the past two years, as were non-controlling interests in other businesses.
Less Common Owners’ Equity Line Items
Less common items are reflected in book value. For example, the drawing account is used for businesses that aren’t incorporated or publicly traded. The drawing account tracks any money that a business owner takes out of the business. If the business has several partners, each partner gets his or her own drawing account. Private firms can also have employee stock ownership plans (ESOP) that issue shares to employees. Loans to ESOPs, such as to fund them initially, represent a contra account and reduce the value of shareholders’ equity.
Important Items to Look Out for When Analyzing the Shareholders’ Equity Sector
Analyzing and tracking a firm’s growth in book value over time is a valuable exercise, especially for stable firms such as Berkshire Hathaway. Basically, this investigates how well (or badly) a firm is managing the capital that shareholders have invested in the company. However, it is important to note that this looks at accounting and historical cost, not market value. Market value is reflected in how well a company’s share price performs over time. Over the long haul, it should resemble book value growth as it has done for Berkshire. Warren Buffett has detailed that book value growth has been a conservative measure as Berkshire's profits are taxed over time, where shareholders can and have owned the stock for many years, avoiding taxes as unrealized long-term gains build. But there can be significant differences over the short term.
Analyzing tangible common equity also has great value. This strips out the value of goodwill and other intangible assets on the balance sheet. Tangible book is meant to more closely analyze the value for a firm if it was liquidated and the proceeds were paid out to shareholders.
Return on equity (ROE) is another important determinant of whether a company is doing its job for shareholders. An ROE in double digits basically indicates a firm is managing shareholder capital well. The higher the better. Below is an overview of Berkshire's ROE to demonstrate that it stacks up well against its insurance industry, but not as well compared to the financial sector:
|Return on Equity (TTM)||9.44||8.76||23.52|
|Return on Equity - 5 Yr. Avg.||7.13||2.87||22.43|
The Bottom Line
Analyzing owners’ equity is an important analytics tool, but it should be done in the context of other tools such as analyzing the assets and liabilities on the balance sheet, the difference of which represents book value. There is also a need to look at the income and cash flow statements for a comprehensive fundamental analysis on a firm.
Fundamental AnalysisAs an experienced or new analyst, liabilities tell a deep story of how a company finances, plans and accounts for money it will need to pay at a future date.
Fundamental AnalysisAmortization is important to account for intangible assets. Read to find out more about amortization.
Fundamental AnalysisThe main purpose of equity valuation is to estimate a value for a firm or security. There are three primary equity valuation models: the discounted cash flow (DCF), cost and comparable approaches. ...
Investing BasicsFor anyone who was invested in Enron, off-balance sheet (OBS) financing is a scary term. Off-balance sheet financing means a company does not include a liability on its balance sheet. It is an ...
Fundamental AnalysisUnderstanding and analyzing OCI greatly improves financial analysis, especially for financial companies.
InvestingWhile stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
EconomicsAfter the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
Stock AnalysisLearn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
Active TradingCompanies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
MarketsLearn how this simple calculation can help you determine a stock's earnings potential.
A share premium account shows up in the shareholders’ equity portion of the balance sheet. The share premium account represents ... Read Full Answer >>
Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>
If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>
Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>
When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
Unearned revenue, or deferred revenue, typically represents a company's current liability and affects its working capital ... Read Full Answer >>