Wednesday, 31 March 2010
Buffett (1980): The true value is determined by the intrinsic value of the company and not the dividends.
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Buffett’s thinking from that 1980 letter.
Let’s break down and expand upon the key ideas you’ve highlighted:
1. Intrinsic Value vs. Dividends in Accounting
Buffett was criticizing the accounting convention that focused on dividends received from partially owned companies as the measure of value for the owning company.
He argued that the real worth to Berkshire wasn’t the dividend payout, but the proportionate share of the underlying business’s intrinsic value — regardless of whether those earnings were paid out or retained.
Your Indian example — valuing M&M based only on dividends from Tech Mahindra, rather than 20% of Tech Mahindra’s intrinsic value — perfectly illustrates the flawed accounting viewpoint.
If Tech Mahindra reinvests its earnings profitably, the retained earnings compound and increase the intrinsic value of M&M’s stake far beyond the dividends received.
Accounting rules at the time (and to a large extent still today) fail to capture this unless ownership exceeds a certain threshold (e.g., consolidation or equity method with impairment tests, but still not intrinsic-value based).
2. Retained Earnings: Value Depends on Use
Buffett’s core point:
“The value of retained earnings is determined by the use to which they are put and the subsequent level of earnings produced.”
This means it’s not retention itself that creates value, but the return on reinvested capital. If a business can reinvest earnings at high rates of return, retaining earnings adds more value than paying dividends.
If it can’t find good reinvestment opportunities, returning capital to shareholders (via dividends or buybacks) is better.
For partial ownership, even if you don’t control the capital allocation decisions, if the investee company reinvests earnings well, your share of its value grows without you receiving cash dividends.
That’s why Berkshire’s holdings in companies like Coca-Cola or See’s Candies were worth far more than the dividends indicated — because retained earnings were deployed into high-return operations.
3. Buybacks at a Discount to Intrinsic Value
The second quote contrasts corporate acquisitions (often full-price or overpay in competitive bidding) with stock buybacks in the open market (where shares can sometimes be bought far below intrinsic value).
Key takeaways:
Acquisition market = auction between corporations → often pays premium to intrinsic value.
Stock market = sometimes an auction where sellers panic → can buy parts of a business at a discount.
Buffett loves buybacks when:
The stock trades below intrinsic value.
The company has excess cash and no better investment opportunities.
Buybacks increase per-share intrinsic value by reducing shares outstanding, effectively giving remaining shareholders a larger claim on future earnings at a bargain price.
4. Relevance Today
These principles remain central to value investing:
Look-through earnings: When evaluating holdings, include your share of undistributed earnings of subsidiaries/associates if they are reinvested well.
Capital allocation priority:
Reinvest in high-return projects.
Acquire other businesses at fair prices.
Buy back stock when cheap.
Pay dividends if no better use.
The accounting standards (e.g., IFRS 9, ASC 323) still don’t fully reflect “look-through” intrinsic value for minority holdings — they focus on dividends, fair value changes, or equity-accounted earnings, but not necessarily the full economic value of retained earnings compounding inside the investee.
5. Buffett’s Broader Philosophy
The 1980 letter segment you’re discussing fits into Buffett’s larger framework:
Own businesses, not stocks → value comes from underlying business performance.
Mr. Market offers opportunities to buy/sell pieces of businesses at irrational prices.
Management’s job is to increase per-share intrinsic value over time, not to cater to short-term stock prices.
By ignoring dividends as the sole measure of value from investments and focusing on the growth in intrinsic value, Buffett built Berkshire’s worth far beyond what dividend-based accounting would suggest.
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SUMMARY
Here is a summary of the article's key points:
Core Argument
Warren Buffett, in his 1980 letter, argues that the true economic value of a company's stake in another business is not determined by the dividends it receives, but by its share of the intrinsic value of the underlying business. Accounting standards that focus on dividend income are misleading.
Main Points
Intrinsic Value Over Dividends:
If Company A owns 20% of Company B, the stake should be valued as 20% of Company B's intrinsic value, not just 20% of the dividends paid out. This is because retained earnings reinvested into the business can create far more long-term value.
Example: Valuing M&M based only on the dividends from its stake in Tech Mahindra would be incorrect; one must value its 20% ownership of Tech Mahindra itself.
The worth of retained earnings depends entirely on how effectively they are reinvested. If a business can reinvest earnings at a high rate of return, retaining them creates more value than paying them out as dividends.
Acquisitions often occur in a competitive auction, forcing acquirers to pay a "full" or inflated price.
Stock Buybacks, however, allow a company to buy parts of its own business in the open market, often at a significant discount to intrinsic value, especially during market panics.
Buffett strongly advocates for buybacks when a company's stock is trading below its intrinsic value, as it is the most efficient use of capital to increase per-share value for remaining shareholders.
Conclusion
Buffett’s philosophy centers on economic reality over accounting convention. A value investor should focus on the growth of intrinsic value from reinvested earnings and take advantage of market irrationality to buy ownership stakes at a discount.
