2011: What’s the proper way to think about goodwill and return on capital?

AUDIENCE MEMBER: Joe Tellinghas (PH), Boston, Massachusetts.

What’s the proper way to think about goodwill and return on capital?

Berkshire’s manufacturing, service, and retail businesses earn pretax returns on tangible capital over 20 percent, which suggests either skilled managers or fantastic businesses. But the return on allocated equity is in the single digits, which looks drab.

Accountants treat intangibles similarly because they have different economics. (Inaudible)

For an indestructible brand like See’s or Coca-Cola, I can see why the intangibles should not be amortized because it’s worth more every year, and your comments on GEICO policyholders were one way to think about that.

But all the tobacco companies have billions of dollars of goodwill in unit sales of cigarettes to claim every year in developed countries, so perhaps they should be amortized. And for Time Warner- AOL, goodwill definitely needed to be amortized.

WARREN BUFFETT: Yeah, goodwill — you mention AOL-Time Warner or something of the sort, it should be written off, actually. It was just a mistake in purchase price.

Goodwill should not be used in evaluating the fundamental attractiveness of a business. There you should look at return on tangible assets, and even then there’s some minor — some other adjustments you may want to make.

But basically, in evaluating the businesses we own, in terms of what the management are doing and what the underlying economics of the business are, forget about goodwill.

In terms of evaluating the job we’re doing in allocating capital, you have to include goodwill, because we paid for it.

So if we buy — you know, Coca-Cola goes back to 1886 and John Pemberton at Jacobs Pharmacy in Atlanta, and there was not a whole lot of goodwill put on the books when he sold that first Coca-Cola.

If you were to buy the company now, the whole company, you’d be putting a figure, you know, of 100 billion or something like that on it.

You shouldn’t amortize that, and you shouldn’t, in judging the economics of the business, look at that.

But in terms of judging the economics of the business that purchased it — we’ll call it Berkshire — then you have to allow for the goodwill, because we are allocating capital and paying a lot for it.

I don’t think the amortization of goodwill makes any sense. I think write-offs of it, when you find out you’ve made the wrong purchase and the business doesn’t earn commensurate with the tangible assets employed plus the goodwill, I think write-offs of it make sense.

But when looking at businesses as to whether they’re good businesses, mediocre businesses, poor businesses, look at the return on net tangible assets.

Charlie?

CHARLIE MUNGER: Well, I think that’s right. But as the gentleman says, when we buy a business, a whole business, we never get a huge bargain and, of course, we may get down toward 10 percent pretax earnings on what we pay.

That isn’t so awful as you think when you — a lot of the money comes from insurance float that costs you nothing.

In other words, if you have 60 billion of float and God gives you 6 billion a year earnings, it’s not all bad.

WARREN BUFFETT: Well, on Lubrizol we’re paying close to 9 billion for the equity, and it earns — and you should make adjustments for debt but it’s not an important factor there — and, you know, current rate of earnings is probably a billion pretax.

And now Lubrizol itself is employing far — you know, they’re employing, you know, call it 2 1/2 billion of equity to earn that billion of pretax, so it’s a very good business, in terms of the assets that are employed. But when we end up paying the premium we pay to buy into it, it becomes a billion pretax on something close to 9 billion.

You have to judge us based on close to a $9 billion investment. You have to judge James Hambrick in running the business based on the much lower capital that he has employed.

It can turn out to be a very good business, and we could turn out to have made at least a minor mistake if it isn’t as good a business as we think it is now, but still is a very satisfactory business based on the tangible capital employed.

Charlie, can you make that clearer? (Laughs)

CHARLIE MUNGER: Well, it’s just — we are not going to buy, in the climate we’re in now, operating businesses that are at all decent for low prices. It’s just not going to happen.