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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 211743  
Subject: B + .7F + .7DT Date: 8/6/2011 12:38 PM
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For a company that mostly invests its funds, valuation at book value
makes a lot of sense. Even for other firms it's not a bad idea.

If we conservatively assume no unusual skill at investment, leverage will
make no improvement, since the industry-wide weighted average return on
capital must equal the industry-wide weighted average cost of capital.
To get some more money to invest, the firm will have to pay a cost, and
the conservative assumption is that those two will cancel and the returns
will be about the same as they would have been without leverage.
So, if you don't assume any unusual skill, earnings will vary as net assets,
specifically the industry-wide average returns on invested assets.

The simplest approximation of the assets to invest is book value.
Book has many flaws--notably handling of intangibles and inappropriate
depreciation rates, and the lack of adjustment to assets of time as
their and earnings power and probable market value change--but it is
at least a single fixed number which isn't too bad an approximation
provided the firm doesn't have a lot of its assets tied up in land.

But...
What we're doing here is using book value as a proxy estimate of the
amount of funds that the firm can invest on a long term basis without
resorting to any leverage
. For some firms, there might be better estimates.

This leads us to our usual notion that under very specific circumstances,
the float of an insurance firm is as good as equity. If there is
a very VERY good reason to expect zero cost of float averaged over time,
and a very good reason to expect that the firm is a going concern,
not in wind down, not shrinking, and likely able to maintain at least
the same level of float for at least another couple of decades, then
we can assume that the firm will get the returns on that float as it
would on equity. Because of the necessity of keeping cash on hand
and imperfections in those strict "evergreen capital" tests, I have
suggested the idea that 70% of the float is as good as equity and the
other 30% is a true liability the way that it is shown on the books
because nothing much can be earned on it reliably or it might shrink a bit.
We've had a number of interesting posts on the "book plus 70% of float" metric.

But, for Berkshire, we're missing one leg of the tripod. That's the
deferred taxes. Though we usually just think of this as a liability
that we'll probably have to pay some day, hoping to put that off for
a while, we should think of that much as we think of the float.
Some will get paid, but other new deferred tax liabilities will accrue.
This is a firm with long investment horizons, and that's no coincidence.
In all of the meaningful ways I can think of, deferred tax is as good as float.
In the same way that float isn't quite as good as equity because
of its restrictions and the fact that it might shrink a bit at some
time, deferred tax should probably get a haircut too.
Let's place the same 30% haircut on deferred tax, as well. There is
no need to keep zero return cash on hand for it, but on the other hand
a single major sale of a profitable position would cause a big drop.

Here are the figures for Berkshire's deferred tax in recent years.
In recent years it has been reported as "income tax, principally deferred",
so I have made the approximation that it is all deferred tax.
Any error in that assumption won't change the trend.

End of Deferred
Year Tax
1995 5588
1996 6838
1997 10539
1998 11762
1999 9566
2000 10125
2001 7021
2002 8051
2003 11479
2004 12247
2005 13649
2006 18460
2007 18825
2008 10280
2009 19225
2010 36352
2011 37809 (to June)

It goes down sometimes when the market goes down because mark-to-market
profits are smaller and therefore the notional tax on those notional
profits changes. But overall, the trend is clear---there is a lot
of deferred tax in place, it is growing, and it is not going away.
The most important thing, back to the starting point: absent any
leverage which could cost money, Berkshire earns money on those
deferred taxes in the same way that it earns on float and equity.

So, I looked at a simple, easy to calculate valuation metric, just
one step more complicated than book+float or book+.7*float.
Simply calculate book + .7*float + .7*deferred tax.
I believe it adds useful value to the question, since we have been
ignoring one of the more important moving parts in Berkshire's outperformance.
Here's how that metric has evolved in recent years.
End of   B+.7f+.7df
Year Per share
1995 20530
1996 27816
1997 37055
1998 56520
1999 56326
2000 60314
2001 59101
2002 66162
2003 78673
2004 85362
2005 91190
2006 106294
2007 117729
2008 104157
2009 125872
2010 148862
2011 155280 (to June)

It should be noted that there is no reason to expect this figure to
match fair value---some sort of average multiple would be expected.
However, as it turns out, the market price of Berkshire has mostly
tracked this figure pretty closely, so it can be considered "as is".
That corresponds to the conservative assumption that 100% of the
available-for-investment assets will be deployed at average rates of
return deserving of no premium, and that the investments will be of
market-wide average quality, longevity and profitability. It also assumes
that book value is "right", of course, in the sense that it's a good
approximation of the conservative market value of the asset in question.

Lastly, since a word is worth but one-one-thousandth of a picture,
here is a graph of the year-end b+.7f+.7dt figures above, intermittently,
and the monthly average market prices of Berkshire's stock.
Here is the graph in linear form.
www.stonewellfunds.com/B7F7Dt_2001-06_lin.jpg

Here is it in log form. This is more appropriate, since constant
vertical gaps have constant meanings in terms of percentages of
over/undervaluation, and a linear trend means a constant growth rate.
But the data do get squished up a bit more, so I've shown both.
www.stonewellfunds.com/B7F7Dt_2001-06_log.jpg

In both graphs, the final highlighted point is Friday's closing
price rather than the average price for the last month.

The conclusion is pretty obvious that on this particular metric of
value, which assumes no above-average investment skill on the part
of management, the firm is unusually cheap right now compared
to its history on that particular metric. On this metric, BRK is around
6% cheaper now than it was in March 2000 at $45,000.

It's not a perfect metric, since ultimately trend earnings power matters
more than book value. Moody's hasn't had meaningful price-to-book
value in the last decade, but has earned lots of money.
However, it's easy to calculate, conservative, and makes some sense.

Jim
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Author: ToddFinances1 Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 178705 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 12:51 PM
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<<On this metric, BRK is around 6% cheaper now than it was in March 2000 at $45,000.>>

Can you send that post to Warren because I want a buyback.

Todd

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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: 178707 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 12:53 PM
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Can you send that post to Warren because I want a buyback.

Interesting arithmetic question.
Do you benefit more from Berkshire doing a buyback at current prices, or your buying shares at current prices?
Best would be Mr Buffett's buying shares and giving them to me, I suppose.

Jim

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Author: ToddFinances1 Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 178710 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 1:07 PM
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<<Best would be Mr Buffett's buying shares and giving them to me, I suppose.>>

There's people like me that have a large chunk of their net worth in BRK so I can't incrementally buy new shares to make any difference but Warren can buy large chunks of B shares during heavy volume days to make a difference. I want my per share earnings to increase even more.

Todd

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Author: RoughlyRight Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 178714 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 1:37 PM
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At the end of 1995, Wesco had a book value of $313 per share. Also, they had deferred income taxes of $36 per share. Charlie said this:

This interest-free "loan'' from the government is at this moment working for Wesco shareholders and amounted to about $36 per Wesco share at yearend 2005. However, some day, parts of the interest-free "loan'' may be removed as securities are sold. Therefore, Wesco's shareholders have no perpetual advantage creating value for them of $36 per Wesco share. Instead, the present value of Wesco's shareholders' advantage must logically be much lower than $36 per Wesco share.

Jim, you could calculate the present value of the interest-free loan with assumptions. You have to assume a holding period, an appreciation rate, a tax rate and a discount rate. I think if you assume a holding period of 10 years, an appreciation rate of 7%, a tax rate of 35%, and a discount rate of 7%, then you get about 30% of the deferred tax as "equity". With a change to 20 years, I think you get about 50% of the deferred tax as "equity". So, assuming 70% as equity seems a bit high.

RR

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Author: knighttof3 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 178718 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 2:07 PM
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The simplest approximation of the assets to invest is book value.
...
What we're doing here is using book value as a proxy estimate of the
amount of funds that the firm can invest on a long term basis without
resorting to any leverage. For some firms, there might be better estimates.


Jim,
I say this with great hesitation, but you lost me there.
Isn't book value the assets that the firm has already deployed? If I borrow $10 million, then proceed to buy land and sit on it (<cough>Berkowitz<cough>) I surely don't have $10 million to invest, unless I liquidate my "business" (land) and use the proceeds.

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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: 178723 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 2:39 PM
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With a change to 20 years, I think you get about 50% of the deferred
tax as "equity". So, assuming 70% as equity seems a bit high.


Hmmm, I'll choose to disagree.
That may be true for a given trade, but for the portfolio as a whole,
on trend the deferred tax is not declining, and not remaining constant,
it is rising. (It's not just the stock portfolio either, doesn't BNSF
have a big bag of deferred tax? ...but I digress). Each position is perhaps
held for only X years, but as the aggregate size of the portfolio is rising,
the deferred tax can rise as well, even if it rises at a rate lower than
that of the overall portfolio. I haven't assumed any growth at all, or
even constancy, merely that the average deferred tax in the decades to
come will be at least 70% ($26bn) of its [real] value today ($38bn).
Seems a very safe assumption to me.

FWIW, I don't think the math of your method is the appropriate approach.
I'm not estimating the present value of an interest free loan, I'm
estimating what fraction of a currently existing interest free loan is
worthy of being considered evergreen capital.
It's inflation that matters not a discount rate, which is best handled
by using an assumption of real price appreciation and no discount rate.
Plus, the biggest variable is missing, which is the anticipated portfolio
size from capital additions and dividend reinvestment as well as price appreciation.
For quite a while to come, the investment portfolio is the destination
for a sizable portion of the earnings. It seems reasonable to assume
as a baseline that the portfolio will be larger in real terms in
10 and 20 years than it is now. A portfolio growing in real terms with
a constant churn rate, constant tax rate, and constant real price appreciation
rate will have a rising, not falling, real pool of deferred tax.
So again, my assumption of 30% shrinkage seems more than adequate.
My actual expectation is that there will be no shrinkage of tax liability
at all in real terms over the next 1-3 decades, once you smooth out
cyclical squiggles, so 100% of today's deferred tax is free to invest
and entirely as good as equity today. But a haircut is prudently conservative.

Right now, the deferred tax really is money in hand which costs nothing and for
which Berkshire gets to keep the investment returns. It hasn't ever
stopped growing on trend in the past at a rate well above inflation, so
it probably won't shrink very much in future if at all. All things
being equal, most if not all of today's deferred tax pool can and will
be invested indefinitely.

I think the tax is much more evergreen than float, for example---there is
no particular reason to think that float will continue to grow, or that
it will even stay the same. Underwriting discipline requires turning
down business in soft markets, which means float reductions.
A reminder is page 7 of the 2004 annual report, showing the
premiums for National indemnity falling from $366m in 1986 to $54m in 1999.
Take a look at the facing page. Can you imagine any public company
embracing a business model that would lead to the decline in revenue
that we experienced from 1986 through 1999? That colossal slide, it
should be emphasized, did not occur because business was unobtainable.
Many billions of premium dollars were readily available to NICO had we
only been willing to cut prices. But we instead consistently priced to
make a profit, not to match our most optimistic competitor. We never
left customers – but they left us.
...
Anyone examining the table can scan the years from 1986 to 1999 quickly.
But living day after day with dwindling volume – while competitors are
boasting of growth and reaping Wall Street’s applause – is an
experience few managers can tolerate.


Jim

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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: 178726 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 2:50 PM
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I say this with great hesitation, but you lost me there.
Isn't book value the assets that the firm has already deployed? If I
borrow $10 million, then proceed to buy land and sit on it (<cough>Berkowitz<cough>) I surely don't have $10 million to invest


A better way to think of it is this:
If you capitalize a company with $10 million, you have $10
million to invest and your returns (absent other knowledge) should be
expected to be the typical returns on a pot of $10m. Your book value is $10m.
So, we use book value as a quick yardstick for your likely returns.

I go further and suggest that, absent any special knowledge of you or
your skill, if you borrow a second $10 million and invest that as well,
your earnings won't go up, since the interest on the loan might (absent
special case knowledge) be expected to approximate the returns on the
second $10 million, so your earnings are no better. The expected
returns are unchanged, and are still the returns typical on $10
million, which is incidentally still your book value even after the loan.
So, whether you have the loan or not, your expected returns are roughly
proportional to the book value, not your total assets.
This strenghtens the rule of thumb that firm, most especially a firm
that principally makes investments, is rationally valued at book value
as a first approximation. Or perhaps at some figure proportional to book value.
(experts in company valuation would use current replacement cost of all
assets rather than book value, but that's a lot more work!
Conveniently, they're the same thing for a company holding stocks and bonds and cash).

I then go on to discuss special cases where things beyond book
value might meet the criterion of "costless investable assets on which
you might reasonably expect to earn returns well into the future".
But normal loans and leverage still don't figure into that.

Jim

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Author: 1kali One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 178727 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 3:20 PM
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Jim,

You are amazing. Who could quote from the 2004 annual report, on point, as well as you.

Thanks.

Elizabeth

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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: 178729 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 3:32 PM
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You are amazing. Who could quote from the 2004 annual report, on point, as well as you.

Naw, there are some Olympic class quoters around here. I'm just an amateur.
But that long slide in business really suck in my head. Only took me 7 tries to find it.
I can't even imagine having the strength of philosophical outlook that
management needed during that long slide in revenues. Steely rigour.

Jim

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Author: 1kali One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 178730 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 3:59 PM
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"Naw, there are some Olympic class quoters around here. I'm just an amateur.
But that long slide in business really suck in my head. Only took me 7 tries to find it.
I can't even imagine having the strength of philosophical outlook that 
management needed during that long slide in revenues. Steely rigour."

Well, I'm glad it stuck in your head and you took the trouble to find it.  It's gems like that that tell the character of yourself and the corporation we are all so interested in.

Thanks, again.


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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: 178733 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 5:29 PM
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I suppose it's worth mentioning one potentially big flaw in this as
a proxy for the value of the firm. It tacitly assumes that the returns
on the available no-leverage-cost assets (book + .7 float + .6 deferred tax)
remains roughly constant through time. This is probably not the case.
The returns on net assets are probably declining on trend, so it probably
takes more dollars of those assets to earn a dollar of on-trend income now.

Obviously Berkshire now owns a lot of assets now which have fairly low
returns on assets compared to earlier years, like the utilities and rails.
On the other hand, these acquisitions have their own built in leverage
(leverage through issued bonds) which seems to be working well, so
perhaps the return on book isn't so different from the prior average return on book.
The starting conservative assumption is that leverage doesn't help on
average but in fact that's not really true. It does in specific cases.

This decay isn't apparently a big thing yet.
As there are no dividends, the returns on the available no-leverage-cost
assets mostly show up as yet more available no-leverage-cost assets.
(this ignores that you can't really extrapolate float growth).
Thus, the slope of the trend line is pretty important.
It doesn't seem to have changed very much---the end-June figure is
smack on the trend line from starting point of the end of 1996.
FWIW, that trend line is a compound growth rate of 10.46%/year or 7.79%/year in real terms.
The S&P real total return has been 2.55%/year in that period, 5.23%/year lower.
That assumes reinvestment of dividends with no dividend tax.

Jim

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Author: carl777 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 178734 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 5:37 PM
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"With a change to 20 years, I think you get about 50% of the deferred
tax as "equity". So, assuming 70% as equity seems a bit high."

If you try to value BRK using anything other than a perpetual "Ongoing Business" model, it is easy to get into hand-wringing over the value of Float, Deferred Taxes, and debt. Jim's equation, if anything, is probably conservative if you assume a long-term going concern model. In a sense, it has a lot of similarity to Tobin's "Q", which is a fairly conservative view of valuation. Most M&A transactions of healthy businesses take place at values above "Q". A downside of the formula is that it values the non-insurance businesses only implicitly, rather than explicitly. At this point in time Jim's formula yields a value very close to the 2-column metric, so one can take their choice or use either as a sanity cross-check on the other. Given the current state of the economy and market, I see the $155K+/A-share the 2 formulas yield as conservative, which is consistent with WEB's view that the 2-column metric is an indicator, but under-stater, of his view of intrinsic value.
Carl

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Author: RoughlyRight Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 178735 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 8:02 PM
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so 100% of today's deferred tax is free to invest and entirely as good as equity today.

Well, Jim, we are going to respectfully disagree on this one. Sure the deferred-tax is likely to grow over time. That will come, in part, from investing more cash into securities that appreciate. Cash that comes from things that already make up book value, float and deferred-tax. If you aren’t careful, you can start double and triple counting. Also, if you want to assume growth rates forever higher than discount rates, you can come up with any numbers you like.

I am going to follow Charlie’s lead and think of the deferred tax as an interest-free loan. I am also going to agree with him that the present value of the loan “must logically be much lower” than the value of the loan.

RR

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Author: RoughlyRight Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 178736 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 8:06 PM
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Most M&A transactions of healthy businesses take place at values above "Q".

Most M&A transactions also don't work out very well for the acquirer.

RR

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Author: texirish Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 178739 of 211743
Subject: Re: B + .7F + .7DT Date: 8/6/2011 9:04 PM
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The point should not be missed that the deferred taxes are already invested, not free cash to invest like float. The do generate earnings, but not new sources of income.

Most of the deferred taxes now are the result of the spread between book and tax rates for capital equipment in the operating businesses. These taxes will ultimately be paid, depending upon the life of the equipment. In the interim, the benefits of same are already included in the operating earnings.

The remainder of the deferred taxes are in the equity portfolio investments - KO, AXP,and the like. They act as leverage in both capital gains and dividends. But this is only about $9 billion of the total DT (1st Qtr - I haven't updated.) There is also a very minor amount of DT associated with the bonds, too small and short term to matter.

In my view, deferred taxes are a minor factor in the value of Berkshire. The DT in the operating businesses are a normal part of such businesses. The DT in the equities are yielding small dividends, and the growth outlook for equities is nothing to get excited about based on their normal prices. When prices drop dramatically, as is now happening, the DT shrinks just as rapidly.

I've actually stopped including them in my estimates of adjusted assets. They add little to the correlation with price and are well within the accuracy of the correlations.

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Author: Technodweeb Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 178744 of 211743
Subject: Re: B + .7F + .7DT Date: 8/7/2011 1:42 AM
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Brilliant post. Thank you Jim.

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Author: michaelservet Big red star, 1000 posts Feste Award Nominee! Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 178770 of 211743
Subject: Re: B + .7F + .7DT Date: 8/7/2011 4:40 PM
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Adding to Texirish's note:

When we get into estimating what we think may be the value of deferred tax liabilities – especially those that we pick up through an acquisition – we get into tricky territory.

Blame it on the accountants. Deferred tax liabilities are often shown net of deferred tax assets, for one thing – but more importantly, the accountants have us lump all deferred tax liabilities into a single category. Some of those reported ‘deferred taxes’ have an economic value to us, and some do not.

In an earlier chart on this thread, we saw a bump up in deferred tax liabilities as a result of the Burlington Northern purchase (and we may have concluded that the market was deficient in not assigning some value to Berkshire with that increase). A substantial portion of that deferred tax slug that we got with the BNSF purchase was created from the tax-incentivized purchase of capital expenditures by BNSF, prior to our acquisition of the company.

BNSF had, and took advantage of, the opportunity to take accelerated depreciation -- essentially writing off the purchases for tax filing purposes and paying lower actual taxes – pre-acquisition. The assets were still on their books for accounting purposes, and despite the quick write-off for taxes, continued to be shown on BNSF’s balance sheet, being depreciated (for P&L purposes, not tax purposes) far out into the future. Putting it another way, the book value of the assets that we are showing on the balance sheet are higher than their future tax-deduction value; the deferred taxes that we are also showing (relative to those BNSF assets) is essentially the difference between ‘tax’ and ‘book’.

As we go forward, we’ll book a piece of that reserved ‘credit’ (residing on the deferred tax line) each reporting period. But it will have no cash flow benefit to Berkshire – no (further) reduction of taxes, etc. It’s a tax break that BNSF got – pre-acquisition – that we’re continuing to show for book-only purposes going forward, post-acquisition.

Now, BNSF will continue to make tax-accelerated capital purchases on our dime – and we’ll get an accelerated tax benefit for those new purchases (along with the replenishment to the deferred tax line). But that’s the accelerated tax benefit on new purchases that we make—not on assets that we acquired in the purchase. The deferred tax ‘credit’ we acquired on our balance sheet does not have an actual cash benefit to Berkshire.

It’s a shame that ‘deferred taxes’ aren’t clearly broken out for us so that we can easily value them, but they aren’t. The challenge for us is that we have to understand their actual nature before we can ascribe value.

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Author: TMFElleMoran Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 179142 of 211743
Subject: Re: B + .7F + .7DT Date: 8/12/2011 1:13 PM
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Whoa. This is my last day as an intern at the Fool, and I've spent the last hour reading and re-reading this post, all the comments, and trying to work out the logic.

I would like to thank you: you all have just taught me, in one hour, more (useful understanding of) accounting, than I learned in 2 years of accounting and finance classes. You're amazing, and this kind of stuff is why I love the Fool.

Oh, and thank you for making me an even happier, more confident BRK shareholder.

Elle

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