8 Most Important Words in Finance and Why

Today, we talk about the 8 most important words in finance and why are they important.

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Most Important Words in Finance. Warren Buffett — Warren Buffett

A couple of years ago, a Masterclass and Coaching Program student and I were doing a training session evaluating a company.

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In this session, we were going through a company’s financial reports. He was asking questions, and I was answering them so he could better and faster go through the reports on his own in the future.

At this point we’d gone through a couple companies like this already so things were progressing smoothly. Until we came across one 8-word sentence.

For this reason we ended up spending about 20 minutes talking about just these 8 words and their various and nuanced meanings.

To enumerate, why were they important. What they meant. What they meant in a real-world sense. How could he use the knowledge of taking the time to understand these 8 words, in-depth to better evaluate every company he looks at in the future.

Reading and understanding financial reports

This is the beauty of reading and understanding financial reports on a deep level…

After you read enough financial reports, they begin looking almost identical in terms of how things are structured and worded.

This is because of the lawyers, accountants, and investor relations people who must abide by laws, rules, and guidelines.

But still every company is different. And if you learn how to spot the differences and take the time to understand them on a deep level you can gain a huge advantage over other investors.

Both “professional investors” – most of whom don’t even read financial reports.

And other stock pickers – because they aren’t willing or able to put in the extra time to understand things on a deep and nuanced level.

Given these points, this is why we spent 20 minutes on just 8 words. To gain a huge level of better understanding he could use to evaluate every company he looks at in the future. So, he can gain a large and legal informational advantage over other investors.

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In time, these things combined will lead him to earning higher investment returns than others.

Today, I want to share this with you so you can do the same.

Always in your service,

Jason

P.S. The only things that have been changed or edited from the live Zoom training session are changes for context and grammar. All other content below is directly from our training session.

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The 8 most important words

In a Case Study live video training session with a Masterclass and Coaching Program student, we were evaluating a company that looks like a great investment when I came across an interesting teaching moment.

It’s one single line, 8 words, not even a full sentence. But is extremely powerful.

So powerful that I wrote it down and printed it off from my computer so I made sure I had the exact wording…

“Have been prepared on a HISTORICAL COST BASIS, except for available-For-Sale FINANCIAL ASSETS and INVESTMENTS which have been measured at FAIR VALUE”

After this session, I asked students in the Value Investing Journey Masterclass Facebook Group the following questions:

What did they think of this line?
And why it is important?

I haven’t got a correct response yet, at least, in terms of why it caught my eye.

Because of this that’s why I want to talk about this today.

Indeed it’s not even one full paragraph, or even one full sentence. But, it’s an ultra-important set of words so let’s begin seeing why…

#1. Historical Cost Basis

They’re talking about financial statements. Specifically the balance sheet.

So these have been prepared on a historical cost basis. That’s an important lesson.

Historical cost basis means whatever the company paid for an asset in the past. Not what it’s worth today.

No matter what the asset is worth today its stated at what its cost was.

This is done properly according to financial and accounting rules and regulations.

#2. Financial Assets

Let’s go to the second part. Except for available For Sale Financial Assets and Investments, which have been measured at Fair Value.

This probably leads to the question my student then asked during the session…

“Is it normal, or can they pretty much manipulate the valuation fair value evaluations to be whatever they want?”

Yes, it is what normal companies do that when they have assets that are quoted and held for sale on the balance sheet. They value them at whatever the fair value is.

Typically, if it’s a stock, it’s the market price. If it’s real estate, it’s an appraisal that is supposed to be fair value.

Then he asked…

“Can you trust the value?”

This goes back to my investing rule number one: “If I cannot trust management, I will not invest in any situation no matter what.“

If you can’t trust management, it shouldn’t matter. You shouldn’t buy the investment if you can’t trust management. No matter what.

He then asked…

“Are they are saying ‘Things available for sale in fair value’ because you should be investing in investment or any opportunity. In my opinion, typically, based on my experience. Most companies are selling a little high.”

This is where things become difficult…

Everyone thinks accounting rules and regulations are black and white. Here’s what you can do and here’s what you can’t do.

It’s not that simple.

There is a lot of gray area – a lot of room for judgements in accounting rules.

Generally, I want companies to be on the conservative side of things. Far away from any kind of legal issues.

But most companies are somewhere in the gray area in terms of their judgements.

In this case it’s a difficult situation where you think you can get this a little bit underpriced.

But I very rarely – off the top of my head – can think of a specific situation where this happened.

Most companies over price their assets in my opinion.

But again, if I find I can’t trust management, I discard the company immediately.

Again, this is normal when assets are deemed as for sale, or assets are held for sale, or whatever the terminology is. It means the same thing.

They are typically valued at whatever is their estimate of fair value, if it’s not something like a stock that has a real and fast moving share price.

This was what caught my eye…

Why it’s so important is because a lot of people don’t know balance sheets are prepared on a historical cost basis.

Similarly I’m talking about the balance sheet here…

To begin with what does that mean?

How is it so important?

Lastly, why did it catch my eye?

I want to talk about this with you

A lot of people don’t know that, let’s say a company X buys company A, and becomes a subsidiary.

It’s going to always be listed as the acquisition price on the balance sheet, unless and until they list the company for sale in the future.

Or historical cost basis. This is also sometimes called carrying value.

In the real-world…

For example, Warren Buffett bought See’s Candy in 1972 for 25 million dollars.

At that time, because it produced excess cash flow that they could redeploy to buy other assets. Because See’s didn’t require a lot of capital expenditure to continue growing or to keep the business profitable.

In 1972 they bought this company for $25 million and only put $40 million in investments into it over the next several decades.

Since then, See’s produced more than $1 billion in operating profit on a total spend of around $65 million as of the early 2000s.

Obviously if a company produces more than $1 billion in operating profits, it’s worth far more than $25 million.

But because it’s not listed for sale, it’s listed on Berkshire’s balance sheet as having a value of $25 million.

Now, we can’t see it anymore on the balance sheet because $25 million is a minuscule number when compared to a company that is worth $530 billion like Berkshire is, but due to accounting rules, we know that it’s still listed on the balance sheet as worth $25 million.

Until and unless Berkshire sells See’s – which it will likely never do – it will always be listed as worth $25 million on the balance sheet. This is due to accounting rules and regulations.

This is where deferred tax assets and Float come in.

Now let’s assume they were going to sell it for teaching sake…

I can guarantee you it would sell for a far higher amount than $25 million due to how much operating profit it has produced in the last several decades.

Investment Float

So, on the books you have an asset that’s worth $25 million, but if you were to sell it could probably sell for more than $1 billion.

So, what that produces on the balance sheet are deferred tax assets and deferred tax liabilities. If Berkshire sold See’s they would have to pay taxes on the difference between whatever the sales price was and the $25 million original purchase price.

This is also called investment float.

If you haven’t watched my series on investment float, you should.

You can read, watch, and learn from free sessions on investment float here.

You’ll get a massive advantage over other people and other investors learning about and knowing what investment float is.

Because you haven’t, I’m going to do a quick recap here…

Investment float is capital you have access to now and can use, but that you may have to pay back at some point in the future.

For example, in this case if they were to sell See’s Candy, they’ have to pay taxes on whatever the difference is between 25 million dollars and the sale price.

But until then they can use the value of See’s – the continued operating profits and increased value of See’s – to grow Berkshire Hathaway by buying other assets.

This is the power of investment float

In essence Buffett can continually use this money to grow Berkshire without having to pay taxes on the money. Legally.

There’s a hidden value when companies have great capital allocation and buy companies or subsidiaries and they produce a ton of value and become more and more valuable.

However most people don’t know anything about the power of deferred tax assets or liabilities, and investment float.

There is no section called investment float in their GAAP or IFRS accounting rules.

Basically you must know what they are and know how to find them yourself.

Buffett talks about it in one of his Berkshire Hathaway annual shareholder letters, at length – financial statements and normal accounting rules don’t show the true value of company growth when it’s based on investment float and real-world economics.

Accounting rules have little to do with the real-world economics of a company.

Again, this is illustrated with See’s having a $25 million value on Berkshire’s books when it has produced more than $1 billion in operating profits since its acquisition.

People like you and I can gain a massive advantage over other people because we know about things like investment float and where to look for them.

8 most important words

“Have been prepared on a historical cost basis…”

Thus these 8 words over an 88-page financial report are enormously important.

These words are in almost every financial report you’ll ever read.

It’s so important to understand what these 8 words mean on a deep level. And how it affects the company in terms of real-world economics.

I told you kind of what goes into my thought processes and why I saw that and thought it was such a great teaching point because again, frankly a lot of people don’t know about this kind of stuff.

Again, eight words out of an 88-page document, which is probably I would guess tens of thousands or hundreds of thousands of words…

Eight words have an enormous amount of power over what the company does from an everyday kind of economic accounting standpoint.

If you know what it means – those eight words, on a deep level, can lead to an investment float.

In the real estate arena

Firstly, let’s say you bought an apartment complex. Let’s say you put 1 million dollars in Capital Improvements to raise rents, then development around the area explodes.

On the balance sheet if you hold this company or if you hold this apartment complex for 10 years and it goes up to $15 million in fair value on the market – just the apartment and land – plus whatever it is producing free cash flow for you on a regular basis.

You can probably sell this apartment complex for $30 to $45 million. And easily more than the $15 million for just the land and the building.

So if it’s producing excess cash flow and the cash flow covers the rent. If the area expands a lot and it becomes hip and upscale. With more development around this apartment complex, it may make the property worth as much as $50 million.

As you reinvest the rents and the cash flow into upgrading the units, you can then begin charging higher rental rates over time… This produces even more excess cash flow. Overall this increases the value of the property by an even larger amount.

This asset would still be listed on the balance sheet for its $1 million original purchase price, even though it would be earning more than that every year in cash flow as time passes.

Same thing with public companies and private companies. They are listed at historical cost basis unless they’re going to be sold.

Again, this can lead to huge differences between the real world economic value and accounting value of the company.

Therefore, you can gain a huge advantage over other investors by knowing what these 8 words mean in a real-world sense and how it can affect an investment.

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