Charlie Munger On Deferred Tax Liabilities And Intrinsic Value
On Float Part 1
The goal of this blog is to help us all improve as investors and thinkers so we’re a little wiser every day. The hope being that our knowledge will continue to compound over time so we’ll have huge advantages over other investors in the future.
The aim of today’s post is to continue this process by talking about a topic few investors know about. And even fewer understand.
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Below is an unedited thread from the value investment forum Corner of Berkshire and Fairfax discussing Charlie Munger’s thoughts on deferred tax liabilities and intrinsic value.
Bolded emphasis is mine below.
So, I’ve been reading Munger’s Wesco letters (they are quite repetitive). However, while reading, I found the following section pretty interesting:
Consolidated Balance Sheet and Related Discussion
As indicated in the accompanying financial statements, Wesco’s net worth increased, as accountants compute it under their conventions, to $2.22 billion ($312 per Wesco share) at yearend 1998 from $1.76 billion ($248 per Wesco share) at yearend 1997.
The $459.5 million increase in reported net worth in 1998 was the result of three factors: (1) $395.8 million resulting from continued net appreciation of investments after provision for future taxes on capital gains; plus (2) $71.8 million from 1998 net income; less (3) $8.1 million in dividends paid.
The foregoing $312-per-share book value approximates liquidation value assuming that all Wesco’s non-security assets would liquidate, after taxes, at book value. Probably, this assumption is too conservative. But our computation of liquidation value is unlikely to be too low by more than two or three dollars per Wesco share, because (1) the liquidation value of Wesco’s consolidated real estate holdings (where interesting potential now lies almost entirely in Wesco’s equity in its office property in Pasadena) containing only 125,000 net rentable square feet, and (2) unrealized appreciation in other assets (primarily Precision Steel) cannot be large enough, in relation to Wesco’s overall size, to change very much the overall computation of after-tax liquidation value.
Of course, so long as Wesco does not liquidate, and does not sell any appreciated assets, it has, in effect, an interest-free “loan” from the government equal to its deferred income taxes on the unrealized gains, subtracted in determining its net worth.
This interest free “loan” from the government is at this moment working for Wesco shareholders and amounted to about $127 per share at yearend 1998.
However, some day, perhaps soon, major parts of the interest-free “loan” must be paid as assets are sold. Therefore, Wesco’s shareholders have no perpetual advantage creating value for them of $127 per Wesco share. Instead, the present value of Wesco’s shareholders’ advantage must logically be much lower than $127 per Wesco share. In the writer’s judgment, the value of Wesco’s advantage from its temporary, interest-free “loan” was probably about $30 per Wesco share at yearend 1998.
After the value of the advantage inhering in the interest-free “loan” is estimated, a reasonable approximation can be made of Wesco’s intrinsic value per share. This approximation is made by simply adding (1) the value of the advantage from the interest-free “loan” per Wesco share and (2) liquidating value per Wesco share. Others may think differently, but the foregoing approach seems reasonable to the writer as a way of estimating intrinsic value per Wesco share.
BREAK HERE. BELOW THIS IS THE WRITERS – NOT MUNGER’S COMMENTS.
It immediately struck me that such an evaluation could easily be applied to Berkshire, although Berkshire at this point is much more complex than Wesco was then. Turns out, someone had already done the analysis for 2011 and 2012:
http://seekingalpha.com/article/282116-berkshire-hathaway-worth-its-salt
http://seekingalpha.com/article/740931-berkshire-hathaway-worth-its-salt-2012-update(As a side note, I had trouble following Dan Braham’s line of thinking on this evaluation in the comments of the first article)
This evaluation contrasts from the “investments per share” and “earnings from owned companies” approach, which I believe was advocated by Buffett more recently.
BREAK… BELOW HERE ARE MY COMMENTS.
The Importance of Float
‘Float is money that doesn’t belong to us, but that we temporarily hold.” Warren Buffett
Why does Munger think the above is a good approximation of Wesco’s intrinsic valuation then? Because while the company “owns” these liabilities on their balance sheet the company can use them to grow the business.
This is an example of float and the power it can have on a company.
Munger only used an estimated 1/5th of the value of Wesco’s float in his valuation. Why? Because when these “assets” are sold it comes off Wesco’s balance sheet.
I agree with Munger that this is a necessary and conservative way to look at valuing float within a company.
And most people overlook float when evaluating companies because they either don’t know what it is. Don’t know the power it can have within a business. Or don’t know how to evaluate it.
This won’t be an issue here.
Press On Research subscribers already know this as I talk a lot about float in many issues I’ve written. But I want to begin talking about it more here for a simple reason. Float is one of the most powerful – and least understood – concepts when evaluating businesses.
We can gain a gigantic advantage over other investors by knowing what float is. How to evaluate it. And and how to value it.
Also, contrary to common belief float can be found in any business. Not just insurance companies.
But we’ll get to this in a later post… In the next post I’m going to explain what float is in more detail.
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Let me know your thoughts on deferred tax liabilities and other float in the comments below.
I do nt understand. Float are money received now, which can possibly be paid later and I can use them now. Deferred tax are money saved later because of saved not paid taxes? Deferred tax is like NOL in my opinion.
Thanks for the comment and question.
You’re right… Deferred taxes in many cases are things like NOL’s and tax credits. But they can also be float.
I’m going to continue to explain the complexities of the confusion around float in coming posts. But know for now the post above and what Munger is talking about deferred taxes – liabilities in this case – should be viewed as float and not NOL’s.
Why?
Because only net deferred tax assets should be considered NOL’s.
Deferred tax assets and liabilities listed on the balance sheet – not net – are float. The difference is subtle but important. And thanks to your question I now plan to write a post explaining the differences.