Charlie Munger: Never Use These Valuation Metrics

Key Concepts

• Depreciation as an Expense: The fundamental disagreement regarding the treatment of depreciation in valuation multiples.
• Float: The time difference between paying for goods/services and receiving payment – a desirable financial characteristic.
• Reverse Float (Depreciation): Spending money before recording the expense, considered unfavorable.
• Two and Twenty (2/20): The standard hedge fund fee structure (2% management fee and 20% of profits).
• IBA (Interest Bearing Assets): A metric used to inflate borrowing power and valuations, considered misleading.
• Reverse Engineering Life: Reflecting on what will bring fulfillment in the future to guide present actions.
• Legacy & Teaching: The speakers’ perspectives on how they wish to be remembered.

Valuation & Financial Practices

The discussion centers heavily on the deceptive practices employed in financial valuation, particularly concerning depreciation. The speakers express strong disapproval of treating depreciation as anything other than a straightforward expense. They equate it to dishonest behavior, using the analogy of a real estate broker falsely inflating square footage. The core argument is that including depreciation in calculations like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) artificially lowers multiples and presents a misleading picture of a company’s true profitability.

As stated, “Depreciation is an expense and it’s the worst kind of expense.” This is because, unlike “float” – where money is received before an expense is incurred – depreciation requires an upfront investment with the expense recognized later, termed “reverse float.” The speakers believe a business with minimal depreciation, indicating little investment in fixed assets, is preferable to one with high depreciation, even if both generate the same earnings (X).

The rise of using Interest Bearing Assets (IBA) in the last 20 years is criticized as a tactic to inflate borrowing power and valuations, benefiting Wall Street at the expense of accurate assessment. It’s described as a “very misleading statistic” that can be used in “pernicious ways.”

The Two and Twenty Problem

The “two and twenty” fee structure common in the hedge fund industry is also condemned. The speakers suggest that the actual performance of many funds, after accounting for the 2% management fee and 20% performance fee, reveals a poor return on investment relative to the expenses incurred by investors. The fact that this structure is now taught in business schools is viewed as a particularly egregious development – “that is horror squared.”

Life Philosophy & Legacy

The conversation shifts to broader life perspectives, particularly regarding legacy and fulfillment. When asked about their dreams, one speaker jokingly expresses a desire to be 90 again, offering advice to younger individuals: “If you got anything you really want to do, don't wait till you're 93. Do it.”

A key concept introduced is evaluating life “backwards,” inspired by Kierkegaard. This involves considering what will bring satisfaction in the future to guide present actions. The speaker elaborates, “You want to sort of think about what will make you feel good when you get older about your life and at least generally want to keep going in that direction.”

Charlie Munger’s perspective on legacy is simple: he enjoys teaching and would be pleased if he were remembered as a good teacher, adding that “to make the teaching endurable, it has to have a bit of wise assery in it.” Warren Buffett’s desired epitaph, humorously, is “That’s the oldest looking corpse I ever saw.”

Anecdotes & Personal Reflections

The speakers share anecdotes about their long-standing partnership, noting they first worked in the same grocery store (though not simultaneously) and have enjoyed a fruitful relationship since they were 29 and 35 respectively. The speaker expresses regret that their collaboration didn’t begin earlier.

A humorous story is recounted about a funeral where no one could say anything positive about the deceased, culminating in someone stating that his brother was worse.

Connection Between Ideas

The discussion seamlessly transitions between specific financial criticisms and broader philosophical reflections. The condemnation of deceptive financial practices serves as a metaphor for a general distrust of systems that prioritize self-interest over honesty and transparency. The emphasis on living a fulfilling life, guided by future satisfaction, provides a counterpoint to the perceived greed and short-sightedness of Wall Street. The anecdotes about their partnership and personal philosophies add a human dimension to the critique of financial systems.

Conclusion

The core takeaway is a strong critique of practices that prioritize short-term gains and misleading valuations over genuine financial health and ethical behavior. The speakers advocate for a more honest and transparent approach to finance, coupled with a life lived with intention and a focus on long-term fulfillment. They emphasize the importance of critical thinking, questioning accepted norms, and prioritizing personal values over external pressures. The conversation serves as a cautionary tale about the dangers of unchecked self-interest and the enduring value of integrity and wisdom.