Earnings season is upon us, as Wall Street chooses which companies to reward for a good quarter or punish for a bad quarter. Wall Streets obsession with earnings happens every quarter, the give and tug of who is rising versus the fallen. As value investors we don’t necessarily play this game, we are much more interested in the long-term outlook, as opposed to the short-term focus of earnings season. Warren Buffett eschews this mania, and instead, he focuses on what he calls “owners earnings.” These earnings to him are a better representation of the true earnings of a company.
This short-term focus that Wall Street has can cause a stock to rise or fall quite quickly, sometimes in the same day. As the bears and bulls of each side of the trade rush in and out to try to get a better position. This volatility can be maddening, and certainly, test the will of many people.
Buffett rises above this madness and instead chooses to hold a long-term approach that focuses more on the fundamentals of the business as opposed to the short-term earnings of one single quarter. These earnings that everyone places so much focus on can, and have been manipulated before, sometimes to great effect.
Many investors have been blindsided by this manipulation and have lost a ton of money because of the greed and deceitfulness of others. One way to avoid this is to do your research, and another is to adopt a long-term view that focuses on the fundamentals of the business and to see that they are doing the right things to grow the business.
What are Owners Earnings?
In the 1986 Berkshire Annual Shareholder Letter Buffett outlined his thoughts on owners earnings.
“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) 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.)”
Hubba, what? That was a mouthful, wasn’t it? Ok, let’s break this down a little bit. I liken it to eating a pizza, you can’t eat it all at once, as much as you would like, but eating it one piece at a time –
Owners Earnings =
- Reported Earnings
+ (b) depreciation, amortization
+/- (b) other noncash charges
- (c) average annual maintenance CapEx
+/- changes in working capital
Some of these terms are a little out of date, as he wrote this in 1986 and accounting rules have changed and there was far less information available then.
Let’s break this down a little bit more so we can make heads or tails of this equation.
Breaking down the Owners Earnings Equation
Reported Earnings: This one is easy, as the net income comes from the income statement.
Depreciation, Depletion, and Amortization: Another easy one, found in the cash flow statement.
Other non-cash charges: Also found in the cash flow statement and includes any charges that don’t involve cash. A great example is employee stock compensation.
Maintenance Capital Expenditure: Another easy one as this is in cash flow statement as well. Although today we know it as the total capital expenditures. In 1986, statements of cash flows weren’t required which would have made it difficult to calculate what a cap ex-was, let alone maintenance capital.
Buffett would have likely used averages to determine this number, but you and I have it easy and we can just use the total capital expenditures number.
Maintenance Capex can be very difficult to calculate it accurately, and this could cause some inaccuracies in our calculations, which would throw off our number.
Far better to be conservative and use the total CapEx number, than to underestimate the maintenance CapEx and pay more for a company.
Working Capital: “Working Capital is defined as the difference between a company’s current assets and current liabilities. Working capital is a measure of a company’s short-term liquidity, or it’s ability to cover short-term liabilities.”
So changes in working capital can be defined as the net change in current assets and current liabilities.
A great way to illustrate this is:
- If the change in working capital is negative, that means working capital increased as the company needs more capital to grow. This reduces cash flow, and so it should reduce the owner earnings. (excluded in this case)
- If changes in working capital are positive, that means working capital decreased as the company has more cash for the company to grow and play with. This increases cash flow, and so it should add to owner earnings. (included in this case)
The above explanation is from one of my favs, Jae Jun from Old School Value.
Simply, this means that as assets grow and the company has more money to reinvest and grow, it will have more cash flow and this will grow owner earnings.
Why did Buffet create Owner’s Earnings?
When most investors look at the bottom line of the income statement, they see the net income; this is the profit that the company has generated for a particular period. Most people use that number to value a business or to calculate earnings per share just from the net income.
Buffett takes a different approach with his owner’s earnings. To understand how this works, let’s think about the possible paths that the net income can take after it’s produced.
The first path is a potential dividend payment, and any funds that go this route will be immediately considered owner’s earnings. The remaining balance of net income after the dividend payment is reinvested back into the business.
After the reinvestment, the money will also have two paths it could travel down. The first path is to use the money to reinvest into the maintenance and care of the existing equipment. The second path is to spend the money to expand the assets of the business, i.e., buy more equipment.
If the funds flow in the first direction, called Capital Expenditures, the company’s book value will display little or not growth, because they haven’t done anything to grow the business. Only maintain the current equipment, while important, doesn’t grow the business.
If the funds flow in the second direction, the money will add new income streams to the company, and the new asset adds to the current equity of the company. This second amount added to the dividend already paid out, and the total would be known as Owner’s Earnings.
Why go through all of this to find the value of a company. First, including the growth of current assets will increase the cash flow of the company, which can be used to grow more assets or paid out as a dividend. If you simply use the net income to calculate earnings per share, then you are not taking into