Effective Business Valuation 117short run, focusing on stock price performance can hide manage-
ment ’ s true operating skill.
In evaluating the quality of management, focus on the variables
that management can control. Concentrate on the operational
effi ciency of the business: in other words, how the money is being
spent. In trade terms, this commonly is referred to as capital allo-
cation. Discover a great capital allocator and you will have discov-
ered a great manager. Good capital allocation can be judged by two
controllable variables within a business: book value per share and
return on invested capital.The Net Value of a Business
Book value is the net worth of a business. It ’ s equal to a company ’ s
assets minus all its liabilities. Great managers focus on increasing
book value each and every year. There ’ s nothing more obvious than
the value created from increasing the per share book value of a
business. If a company ’ s per share book value is higher than it was
the previous year, then value was created. It ’ s that simple. Naturally,
long - term annual growth in per share book value is more indicative
of superior operating performance. Management has no control
over the value of the stock price; it does have complete control over
the assets of the business and hence the change in book value each
and every year. Since Warren Buffett began writing the Berkshire
Hathaway letter to shareholders, he begins each one in this way:Our gain in net worth in 2007 was... which increased the per
share book value of both our Class A and Class B stock by 11%.
Over the last 43 years (that is, since present management took
over) book value has grown... [at] a rate of 21.1% compounded
annually.By starting each annual letter this way, Buffett is defi ning the
ultimate yardstick that should be used to grade management:CH006.indd 117CH006.indd 117 9/2/09 6:58:10 PM9/2/09 6:58:10 PM