In the 1986 shareholder letter Buffett delves into what he calls “owner earnings”, which is what he deems to be the correct metric to use for company valuation purposes. When Buffett went into owner earnings it was also a critique against what many deem to be a company’s “cash flow”. Although he does not specifically mention it in the 1986 shareholder letter, he has criticized the term elsewhere – EBITDA, a metric used by many people as a proxy for “cash flow, is an example of “cash flow” that is heavily flawed.

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Warren Buffett

Warren Buffett

The primary reason cash flow metrics like EBITDA or net income plus depreciation and amortization (D&A) are not fully reflective of a company’s cash flow is because they leave out two recurring cash flow changes that most companies experience every year: capital expenditures and changes in working capital. In other words, EBITDA overstates a company’s cash flow by not taking a charge for CAPEX and working capital while the other common method of simply adding depreciation back to net income also is inaccurate – adding back depreciation without any adjustment for a recurring capital expenditure paints the false picture of a company that does not need to spend any CAPEX to maintain its competitive position or unit volume. It’s not a realistic picture. See the excerpt below from the 1986 shareholder letter:

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“If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) [i.e. non-recurring non-cash charges] less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)

Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes - both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.

So what is the best way to estimate (c) the “average annual amount of capitalized expenditures for plant and equipment”?

We can think of a couple of ways. Because D&A charges can fluctuate, one could take the average D&A over several years, with the average taken over more years if there are longer life assets on the company’s balance sheet. One could also take the average CAPEX from the cash flow statement and deduct this figure. The tricky thing with both methods is that part of the CAPEX will be maintenance CAPEX and part will be growth CAPEX.

Here is another excerpt where Buffett describes the flaw of EBITDA in the 2000 shareholder letter:

“When Charlie and I read reports, we have no interest in pictures of personnel, plants or products. References to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures? We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something. And we don’t want to read messages that a public relations department or consultant has turned out. Instead, we expect a company’s CEO to explain in his or her own words what’s happening.

No the tooth fairy does not pay for CAPEX. We have to account for it to assess a company’s true earnings power.

There have been numerous warnings about EBITDA throughout the years in the shareholder letters. Here is an excerpt from the 2002 shareholder letter:

“Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?

And more recently from the 2014 shareholder letter:

“Depreciation charges, we want to emphasize, are different: Every dime of depreciation expense we report is a real cost. That’s true, moreover, at most other companies. When CEOs tout EBITDA as a valuation guide, wire them up for a polygraph test.

EBITDA is not a totally useless metric as a proxy for cash flow available to all stakeholders (i.e. debt holders, the government, equity holders, etc). We think it’s very valuable especially if it has been adjusted for non-recurring charges, particularly those of the non-cash variety. But Buffett is right, as depreciation is a real, ongoing expense – hence, having EBITDA minus ongoing, recurring CAPEX (EBITDA – CAPEX) paints a more accurate picture of a business as a going concern. Taking a multiple of EBITDA minus CAPEX is a way of valuing companies that must be considered.

Article by S&C Messina Capital Management

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