Why Net Income is Worse Than Useless

When it comes to understanding financial statements and the nuances of investing, Warren Buffett's insights are invaluable. Recently, Buffett made headlines by stating that net income, a commonly used measure of a company's profitability, is "worse than useless" for investors. But what does he mean by this? Let's dive into the reasons why Buffett believes net income can be misleading and what investors should focus on instead.

Understanding the Volatility of Net Income

Berkshire Hathaway, Buffett's conglomerate, reported a wild fluctuation in net income over recent years: from a $90 billion profit in 2021 to a $23 billion loss in 2022, and then a rebound to a $96 billion profit in 2023. This kind of volatility in reported profits isn't an anomaly; it's been a pattern since 2017.

So, why is this happening? The primary culprit is an accounting rule change in 2018 that required companies to include unrealized gains and losses on their holdings in their income statements. For a company like Berkshire Hathaway, which holds substantial stock in other companies, this means reporting gains or losses on investments regardless of whether they were actually sold. The result? Huge fluctuations in reported net income that don’t reflect the company's actual performance.

The Problem with Unrealized Gains and Losses

Unrealized gains and losses can significantly distort a company's net income. For instance, Berkshire Hathaway has over $350 billion invested in companies like Apple, Bank of America, and American Express. Due to the accounting rule change, any fluctuation in these stocks' market prices affects Berkshire's net income, even if the stocks haven’t been sold. This makes net income a less reliable indicator of the company’s real financial health.

And it’s not just Berkshire. Many companies that hold significant equity positions in other businesses face the same issue. For example, Shopify's net income was heavily influenced by its investment in Affirm. When Affirm went public in 2021, Shopify had to report its equity position as a profit. But when Affirm's stock price plummeted in 2022, Shopify then had to mark down the investment as a loss. These swings were reflected in Shopify's net income, making it appear far more volatile than the company's core business performance actually was.

Earnings Manipulation: A Common Pitfall

Another reason Buffett criticizes net income as a metric is its susceptibility to manipulation. Companies can, and sometimes do, manipulate their earnings figures—legally or otherwise. They might recognize revenue before it’s actually earned or inflate sales figures through practices like channel stuffing. Similarly, companies can manipulate expenses by capitalizing costs over several periods or by adjusting depreciation practices.

Buffett himself has mentioned that he could manipulate Berkshire Hathaway's net income to reflect almost any figure he wanted, though he would never do so. The point he makes is that it’s possible for executives to inflate or deflate net income figures to serve their own purposes, whether to achieve bonus targets or to inflate the company’s stock price.

External Factors: Another Layer of Complexity

Net income can also be heavily influenced by external factors that have little to do with a company's actual performance. Changes in tax laws, currency exchange rates, or commodity prices can all impact net income. For instance, Apple's profits have been significantly affected by currency fluctuations because it does a large portion of its business outside the U.S. Similarly, changes in tax regulations impacted Netflix’s profitability in 2020.

These external factors can cause significant swings in net income that don’t necessarily reflect a company’s operational health or long-term profitability.

What Should Investors Focus On?

Given these issues, Buffett suggests that net income should only be a starting point for evaluating a company. Instead, he recommends focusing on operating earnings, which provide a more consistent and clearer picture of a company's profit-generating capabilities. Operating earnings exclude many of the volatile and one-time factors that can distort net income.

For Berkshire Hathaway, and other companies affected by similar accounting rules or external factors, focusing on operating earnings rather than net income offers a more reliable view of financial health. Additionally, Buffett advises looking at other financial metrics like gross margin, return on equity, owner’s earnings, and free cash flow, which can provide deeper insights into a company’s true financial performance.

While net income is a widely used financial metric, Warren Buffett’s view is that it can often be "worse than useless" due to the impact of accounting rules, potential manipulation, and external factors. For investors looking to understand a company's real performance, it’s essential to look beyond net income and focus on more stable and telling indicators like operating earnings and cash flow metrics.

By following Buffett's advice and digging deeper into financial statements, investors can gain a better understanding of a company's true financial health and make more informed investment decisions.