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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 211936  
Subject: Re: Brooklyn Investor: 10x pretax earnings Date: 4/2/2014 12:43 PM
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...and (4) available at 10x pretax earnings or cheaper.

To the extent that Mr Buffett values firms on their pretax earnings,
that has to be amended to "10x pretax earnings or cheaper in Berkshire's hands".

BrooklynInvestor is a very smart guy but on this one he has headed
off into the weeds and ended up with some muddled thinking.
It's 10% (or whatever %) pretax in the hands of Berkshire that matters.
You can't compare, for example, a preferred stock that Berkshire could buy with 10%
yield and shares in an ex-growth firm earning $10/share pretax and $6.50 after tax earnings.
Assuming flat earnings for comparable number of years the first one is the no brains winner, by 35%.
An extra layer of taxation makes a difference that can not be (and is not) ignored.
Some things have it and some things don't.

The notion that some of Mr Buffett's purchases for Berkshire happened to be
at 10x pretax earnings is no evidence at all that that's what he'd thinking.
It's just a red herring, like saying several of them had blue logos so
that must be why they were bought. Coincidences, no more.
In recent years Berkshire is too big to find things with attractive valuations
based on a conventional multiple of current earnings (pretax or not).
Now they have to be looking where the puck is headed next: valuing
based on earnings into Berkshire's hands a decade in the future.
The salient purchase metric on BNSF is the ratio of earnings now to price back then : )
We can't really know what hurdle rate they're using—8%,10%,15%—
but we can be absolutely sure it's not the investee's internal pretax rate they're looking at.
Rather, it's the net economic benefit to Berkshire that matters.
Mostly that's closely correlated with the pretax earnings stream into Berkshire's hands.

The only place where this is complicated (a relatively minor effect by comparison)
is in assessing the difference between the different tax rates on
different kinds of income arriving at head office.
Imagine firm A earning $10 after tax EPS paying no dividend, and firm B
earning $10 after tax EPS and paying out $5 as a dividend, with
economics such that the pretax total returns of both in terms of
dividends and stock price appreciation, suitably discounted, are the same.
The nasty calculation for Berkshire management in deciding between these two
is figuring out how long you're going to hold the investment.
If it's a finite span then the second one is much better because Berkshire's tax on
dividends upstreamed to them will be much lower than capital gains on sale of shares.
Some things pretax in Berkshire's hands are worth more than other things pretax into Berkshire's hands.
But if it's a very long period then the first one is perhaps better because
the capital gains tax, though higher, can be deferred indefinitely and adds to float.

But in no case does the internal pretax earning rate within either firm matter a whit.
Buying shares with $20 pretax EPS with 50% tax rate is economically the same
to a buyer of stock as a firm with $12.50 pretax EPS and a 20% tax rate.
[Unless you have some strong evidence that tax rates are about to change!]
To pay more for the first one would be nonsensical.

Jim
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