(May 4, 1998) Warren Buffett explains his approach in estimating the intrinsic value of a business. While book value is one factor to consider, the key factor in estimating the intrinsic value is the future earning power of a business.
Warren Buffett: Key Factor In Estimating The Intrinsic Value
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Good afternoon Mr. Buffett and Mr. Munger. My name is Jack satin from New York City. I have two questions. The Japanese stock market has been likened to the U.S. market in 1974 with Japanese stocks selling at very low price to book values as compared to U.S. stocks. Would it not make sense to invest in a basket of Japanese stocks or an index fund of Japanese stocks. Question number two Berkshire Hathaway tends to invest in companies with high margins and high return on common equity. Berkshire's investment in the airline business seems to have digressed widely from those principles. Could you elaborate on why Berkshire invested in the airline industry and would Berkshire consider new investments in the industry in the future.
Going to the first question. The reason that I don't know the exact figures the Japanese stocks would sell on a lower price book ratio than U.S. stocks is simply because Japanese companies are earning far less on book than American companies and earnings are what determine value. Not book value. Book value is not a factor we consider future earnings are a factor we consider and as we mentioned earlier this morning earnings have been poor for a great many Japanese companies. Now if you think that earnings that the return on equity of Japanese business is going to increase dramatically then you're gonna make a lot of money I mean in you're correct you're going to make a lot of money in Japanese stocks but the returns on equity return on equity for Japanese businesses has been quite low and that makes it a low price to book ratio very very appropriate because earnings are measured against book and companies earning 5 percent on book value I don't want to buy our book value. If I think it's going to keep earning 5 percent on book value so a low price book ratio means nothing does. It does not intrigue us. In fact if anything we are less likely to look at something that sells in a low relationship to book than something that sells at a high relationship to book because the chances are we're looking at at a poor business in the first case and a good business in the second case.
The other question in Germany of buying a the airlines. All eyes. I always repress everything on airlines I don't want to.
We never we've never bought an airline common stock that I can remember. So what we did was we lent money to U.S. air for a 10 year period and we had a conversion privilege there. It looked like it was a terrible mistake. I made the mistake but we got bail out but we we've never made the determination when we bought our stock. U.S. Air was selling at fifty dollars a share. They're about to the common and we didn't have an interest in buying U.S. air at 50 or 40 or 30 or 20. And we got a chance to as things went along all the way down to four.
And we never bought it and we never bought American or United or Delta or any other airline.
It is not a business that intrigues us. We did thing it was intriguing to to lend money to them with a conversion privilege. And it's worked out now is it because we got lucky and because Steve Wolfe came along and and really rescued the company from right at the brink of bankruptcy but we're unlikely to be in airlines although again we wouldn't mind lending money to a lot of businesses that we wouldn't buy common equity in I mean that that that could happen again in various industries including the airline industry. Charlie do you have anything to say on either the airlines or the Japanese market.
Well the airline experience was very unpleasant for us. The net worth just melted. It was a bit like a billion and a half and it just went to one hundred million one hundred million one hundred million. And finally the cash is running down. It is a very unpleasant experience. And. We try and learn from those experiences but we're very slow learners. Japanese American Oh the Japanese market. I suppose anything. I suppose anything could happen. After all we bought silver. But. We have never made a big sector play on a country that we have almost never made a big sector play.
We would have to come to the conclusion that Japanese business instead of earning whatever its earning on equity now is going to earn appreciably more on equity. I've got no basis for it. I wouldn't argue with anybody else feels that way. I wouldn't argue with them but I have no basis for coming to a conclusion and unless you come to that conclusion you're wrong I make good returns. I mean less that unless that happens you're not going to make good returns from Japanese stocks that you cannot. You can't earn a lot of money from businesses that are earning 5 percent or 6 percent on equity. And I look at the reports but I don't see I don't see the earning power now. Now maybe it'll all change. I mean there's there's talk of there's already been a small temporary tax cut but corporate tax rates are quite high as you know and in Japan and they used to be 52 percent here in the United States now they're 35.
So you could have things happen that increased corporate profits but I don't have any special insight into that that anyone that reads the press generally would not have.
There are also readings in corporate culture that have to be made owning stock in a corporation where you know that if shareholders or somebody else has to suffer the choice is likely to be that somebody else will be chosen. That is a different kind of a company to invest in than one that thinks that the principal purpose of life is to keep some steam boiler company going in a particular community or something no matter how much the shareholders suffer. I think it's hard to judge corporate culture in the foreign countries as well as we can judge it in our own.