By Michael Richards, Value Investor and Builder of MyOmaha.ai
In the 1978 letter to Berkshire Hathaway shareholders, Warren Buffett discussed the company’s financial performance, the impact of its merger with Diversified Retailing Company, and the distinction between operating earnings and capital gains — a principle still vital for value investors today.
The Merger Impact
Buffett explained that the merger made Berkshire’s financial statements more complex.
With ownership of Blue Chip Stamps increasing to about 58%, Berkshire was required to consolidate Blue Chip’s full financial results — including sales, expenses, receivables, inventories, and debt.
He wrote:
“This full consolidation of sales, expenses, receivables, inventories, debt, etc. produces an aggregation of figures from many diverse businesses — textiles, insurance, candy, newspapers, trading stamps — with dramatically different economic characteristics.”
In other words, Berkshire now looked like a collection of different businesses under one roof, each with its own rhythm of risk and reward.
Strong Performance and Caution Ahead
Buffett reported another year of excellent results.
“Operating earnings, exclusive of capital gains, at 19.4% of beginning shareholders’ investment were within a fraction of our 1972 record.”
He highlighted that operating earnings were the best way to measure the company’s health — not short-term capital gains.
While Berkshire’s net worth had nearly doubled over three years (a compound rate of about 25%), Buffett cautioned that this pace wouldn’t last. He expected a downturn in the insurance cycle in 1979, reminding readers that not every year would be a record-breaker.
Still, he remained optimistic about Berkshire’s long-term investments, writing:
“In the longer run, however, we feel that many of our major equity holdings are going to be worth considerably more money than we paid.”
Capital Gains vs. Operating Earnings: What Buffett Really Meant
This distinction — between capital gains and operating earnings — is one of Buffett’s most important lessons.
He wanted shareholders to focus on how much money the business actually makes, not how much its investments appear to make in a given year.
Let’s unpack this in simple terms.
Operating Earnings: The Business Engine
Operating earnings measure how much profit a company makes from its day-to-day work.
For Berkshire in 1978, that meant money earned from its core operations — insurance underwriting, textiles, candy, newspapers, and other businesses.
Buffett likes this number because it shows how efficiently the business itself creates value — not how lucky or unlucky its investments were that year.
Capital Gains: The Side Effect
Capital gains come from changes in the value of investments — for example, when Berkshire’s shares in another company rise in price.
They matter for long-term growth, but they can swing wildly and don’t reflect the strength of the underlying business.
A Simple Example
Imagine you own a lemonade stand.
- Every week, you earn $20 selling lemonade. That’s your operating earnings — the money your business makes from doing its main job.
- One day, you sell your old bicycle for $100. That’s a capital gain — it’s a one-time profit, not something your lemonade stand will do every week.
Now, if someone asked, “How’s your lemonade business doing?”
and you said, “Great, I made $120 this week!” — that would be misleading.
Only $20 came from the business.
The other $100 came from selling something else.
If you want to know whether your lemonade stand is a good business, you need to focus on the $20 — not the one-time $100.
That’s how Buffett thinks about Berkshire:
He cares about the engine, not the noise.
Why This Matters for Intrinsic Value
For investors, separating these two types of earnings is essential to finding a company’s true worth (intrinsic value).
Here’s how that works algorithmically:
- Extract operating earnings from the company’s financials.
- Exclude one-time capital gains or accounting adjustments.
- Project future operating performance based on consistent historical data.
- Discount those future cash flows using a rate that reflects risk (the Weighted Average Cost of Capital, or WACC).
- Compare the calculated intrinsic value per share to the current market price.
If intrinsic value > market price, the stock is undervalued — a potential opportunity.
If intrinsic value < market price, it may be overvalued.
Buffett was doing this long before AI or machine learning existed — just with a calculator and discipline.
Key Takeaway
Buffett’s 1978 letter teaches one of the most practical investing lessons of all:
“Judge a business by the cash it consistently generates, not by the market’s applause.”
Operating earnings show what the business is.
Capital gains show what the market thinks.
Understanding that difference — and weighting it properly — is the foundation of true value investing.
If you believe investing is about owning great businesses, not chasing hype, then we built something for you.
Explore Omaha, a research platform designed to help you think like an owner. Visit → https://www.MyOmaha.ai
Leave a Reply