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But when evaluating a business, whether it is good, mediocre, or weak, look at the return on net tangible assets. Hello friends, this excerpt from the 2011 Berkshire Hathaway Annual Meeting provides great insight into how Warren Buffett thinks about acquisitions and goodwill, as the excess of the purchase price over the underlying equity of a business.
I will pause the video at certain points and elaborate on what Buffett is talking about. I will also provide actual numbers and show how he considered acquiring Lubrizol in 2010–2011. Let's see. In general, when evaluating the businesses we own from the perspective of management actions and fundamental business economics, forget about goodwill.
But when evaluating our capital allocation performance, you have to consider goodwill because we paid for it . So, what's going on here? Buffett points out two things. There is the company itself and there is the buyer, in this case Berkshire Hathaway. Warren says the company operates independently of its parent company.
So if Berkshire Hathaway pays an additional amount for this business, as in the case of Lubrizol, Lubrizol itself does not automatically receive additional capital. She only has the fixed capital that was already in the business, and that will be important in a moment. For Lubrizol, we pay about 9 billion for the stock and it earns, and you should make an adjustment for debt, although it's not such a significant factor here.
I want to stop right here. Warren mentioned this almost in passing, but it's important to really bring this point up. When you look at the business itself, Berkshire looks at the company as if it were 100% financed by equity. Warren means that you can't just look at equity. You need to look at all the capital used in the business, including debt.
So, he says that in the Lubrizol case, there was a small amount of debt. It was quite insignificant relative to the purchase price. I think he ignored it for the sake of simplicity of explanation. But it is very important to understand that when assessing the fundamental attractiveness of a business, all sources of its financing should be taken into account.
So, you know, the current level of pre-tax profit is probably a billion, and Lubrizol itself uses significantly less capital— say, two or two and a half billion of equity— to generate that billion in pre-tax profit. This is a very good business from an asset utilization perspective, but after paying the premium we paid for the purchase, it turns into a billion in pre-tax profit of close to 9 billion.
So you have to value us based on an investment approaching $9 billion. You have to judge James Hambrick's work based on the much smaller capital he used to run the business. This could turn out to be a very successful business, and we could make at least a minor mistake. If the business turns out not to be as good as we think it is now, it still remains quite satisfactory, based on the material capital used.
So let's stop there and look at the numbers on the screen. Again , these are simplified and not based on Lubrizol's exact figures, but they illustrate the point well. So , we see that James Gambrick's business in Lubrizol generates 40% profit before capital gains tax. This is a phenomenal indicator for business.
But we also see that because of the premium Berkshire paid for Lubrizol, the initial yield is significantly lower. So you can calculate it like this: if you take 9 billion—this base for the assessment that I was talking about— divide it by 2.5 billion, get a multiplier, and divide 40% by this multiplier, we get 11%.
So, it's all interconnected. Now another related point is reinvesting additional capital into this business. If Lubrizol can grow, the capital needed for that growth, while generating the same profits as before, will be based on the foundation of the business itself. Therefore, any future capital invested in Lubrizol does not require a re-payment of goodwill.
This is a very important point because it means Berkshire can pay a higher price for the business and then gradually unlock higher future profitability. So, if Lubrizol can earn 40%, 30%, or even 20% on capital. Berkshire's initial return of 11% will be pulled up to the level of return on reinvestment.
Of course, the business itself could change radically , but looking at Lubrizol's history, the excellent profits it has made in the past, and its recent history, the odds were good then and remain good now that the business itself will continue to be successful. In the next segment, Buffett talks about a very important related part—the amortization of goodwill.
You will hear him say that the future regular write-off of goodwill, which accounting rules no longer require, does not affect the core business and its attractiveness. You can add it back, but as he says, writing off goodwill in the event of permanent impairment, as we saw in 2020 with Precision Castparts, makes sense.
So I'll let Buffett speak for himself. I don't think amortization of goodwill makes any sense. I believe that writing it off when you realize that you made a bad purchase and the business is not generating income commensurate with the tangible assets and goodwill used makes sense. I hope this video really helped you understand that, just like when buying a stock, the company's performance and the stock's return can diverge, and similarly, when Berkshire buys a business outright, it doesn't change the business itself.
I hope this gives you some insight into why Berkshire is comfortable paying higher multiples for these good companies, and I hope it helps you with your own investments. So please, if I missed anything, if you have any questions about this or any other general questions, let me know. I'll be happy to answer them in the comments, maybe even make a video about it .
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