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🎵Wisdom Density:
Moderate
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📊 Normal Earning Power
📝 Description
Normal Earning Power is a valuation concept used by Warren Buffett to estimate the intrinsic value of a business by filtering out cyclical troughs or temporary economic anomalies. Instead of looking at current "as-reported" earnings during a recession or localized slump, Buffett calculates what the business would earn if the surrounding economy were operating at a "normal" or historical-average level of capacity.
🔗 Connection to Berkshire
In the 2010 Letter, Buffett applied this concept most aggressively to Berkshire’s housing-related subsidiaries:
- Clayton Homes, Shaw Industries, Johns Manville, MiTek, and Acme Brick: These businesses were operating at severely suppressed levels in 2010 due to the collapse of the US housing market (approaching only 500,000 new home starts annually vs. a 1.25 million historical average).
- The Calculation: Buffett estimated that if the US was building 1.25 million homes (the "Normal" level), these subsidiaries would together earn roughly $2 billion lower in the current year than their potential.
- Valuation Insight: By using "Normal Earning Power," Buffett can justify holding or acquiring assets at prices that might look expensive on a current P/E basis but are remarkably cheap relative to their long-term economic yield.
📅 Evolutionary History
- 2010 Letter: First major explicit discussion of the concept in the context of the BNSF acquisition and the housing slump. Buffett notes that BNSF added roughly $1 billion per month to Berkshire's "normal" pre-tax earning power.
- 2010 Meeting: Buffett explains that the "normal" figure is a moving target but provides a more accurate compass for true Intrinsic Value than volatile quarterly reports.
📈 Key Insights
- Ignoring the Trough: This concept is the antidote to "scare-based" selling. It requires the investor to have a firm conviction in the eventual "normalization" of the macroeconomy.
- Capital Allocation: It guides Buffett's Capital Allocation decisions, allowing him to deploy billions when "current" earnings are non-existent but "normal" earnings are durable.
🔗 Connections
- Related: Intrinsic Value
- Related: Capital Allocation
- Related: BNSF
- Context: 2010 Letter, 2010 Meeting
📚 Historical Mentions & Citations (1)
Click a reference document below to expand and read the exact paragraph(s) containing this concept in the archive.
📜2010 LetterExcerpt Available▼
2010 LetterExcerpt Available
A “normal year,” of course, is not something that either Charlie Munger, Vice Chairman of Berkshire and my partner, or I can define with anything like precision. But for the purpose of estimating our current earning power, we are envisioning a year free of a mega-catastrophe in insurance and possessing a general business climate somewhat better than that of 2010 but weaker than that of 2005 or 2006. Using these assumptions, and several others that I will explain in the “Investment” section, I can estimate that the normal earning power of the assets we currently own is about $17 billion pre-tax and $12 billion after-tax, excluding any capital gains or losses. Every day Charlie and I think about how we can build on this base.
In our earlier estimate of Berkshire’s normal earning power, we made three adjustments that relate to future investment income (but did not include anything for the undistributed earnings factor I have just described).