Warren Buffett On Owner’s Earnings – Analyzing Capital Expenditures by CSInvesting
"If you want to beat the S&P 500, here's what you do, you buy 500 stocks, and then you sell the airlines. You should do better." - Tom Gayner
A reader asks about Owners' Earnings.
According to Buffett Owners Earnings = a) Net Reporting + b) Depreciation, Amortization - c) Capex (Maintenance & Growth).
Buffett says if a+b is greater than c, then Company is earning sufficient amount for the shareholders.
My query is how do we come to a value on Capex? Not precise but on a rough basis?
I suggest that you look at an average of the past 5 years of capital expenditures versus asset growth and calculate average maintenance capex. Maintenance capex (MCX) is mandatory while growth capex is not. See previous post on growth vs. maintenance capex here.
But most importantly, look at the business and its competitive landscape. Does the business lack barriers to entry so that much of the firm’s capex goes to staying in place or fending off competition? Compare the company’s capex to its competitors. A recent case study is in the Wall Street Journal today (November 17th, 2011).
Sears Suffers as It Skimps on Stores
While retail experts estimate that store chains traditionally spend $6 to $8 per square foot on annual maintenance, Sears is spending a fraction of that amount, said Matthew McGinley, managing director of International Strategy & Investment Group, an investor research firm.
“With roughly 250 million square feet domestically, (Sears) is spending about $1.90 a foot, which is a quarter of what you need to maintain share and keep it as an acceptable place to shop.” Mr. McGinley said. (Of course, this might indicate that Sear’s true owner’s earnings are overstated due to the lack of competitive maintenance capex.)
Also, you should break-out growth from maintenance capex. Buffett says owner’s earnings are the earnings available to an owner on a steady state basis (without growth).
I included a few articles and Buffett’s own words on how to calculate owner’s earnings.
Warren Buffett on Owner’s Earnings (1986 Berkshire Annual Report)
Many business acquisitions require major purchase-price accounting adjustments, as prescribed by generally accepted accounting principles (GAAP). The GAAP figures, of course, are the ones used in our consolidated financial statements. But, in our view, the GAAP figures are not necessarily the most useful ones for investors or managers. Therefore, the figures shown for specific operating units are earnings before purchase-price adjustments are taken into account. In effect, these are the earnings that would have been reported by the businesses if we had not purchased them.
A discussion of our reasons for preferring this form of presentation is in the Appendix to this letter. This Appendix will never substitute for a steamy novel and definitely is not required reading. However, I know that among our 6,000 shareholders there are those who are thrilled by my essays on accounting - and I hope that both of you enjoy the Appendix.
Warren E. Buffett
Chairman of the Board
February 27, 1987
As you've probably guessed, Companies O and N are the same business - Scott Fetzer. In the "O" (for "old") column we have shown what the company's 1986 GAAP earnings would have been if we had not purchased it; in the "N" (for "new") column we have shown Scott Fetzer's GAAP earnings as actually reported by Berkshire.
It should be emphasized that the two columns depict identical economics - i.e., the same sales, wages, taxes, etc. And both "companies" generate the same amount of cash for owners. Only the accounting is different.
So, fellow philosophers, which column presents truth? Upon which set of numbers should managers and investors focus?
Before we tackle those questions, let's look at what produces the disparity between O and N. We will simplify our discussion in some respects, but the simplification should not produce any inaccuracies in analysis or conclusions.
The contrast between O and N comes about because we paid an amount for Scott Fetzer that was different from its stated net worth. Under GAAP, such differences - such premiums or discounts - must be accounted for by "purchase-price adjustments." In Scott Fetzer's case, we paid $315 million for net assets that were carried on its books at $172.4 million. So we paid a premium of $142.6 million.
The first step in accounting for any premium paid is to adjust the carrying value of current assets to current values. In practice, this requirement usually does not affect receivables, which are routinely carried at current value, but often affects inventories. Because of a $22.9 million LIFO reserve1 and other accounting intricacies, Scott Fetzer's inventory account was carried at a $37.3 million discount from current value. So, making our first accounting move, we used $37.3 million of our $142.6 million premium to increase the carrying value of the inventory.
Assuming any premium is left after current assets are adjusted, the next step is to adjust fixed assets to current value. In our case, this adjustment also required a few accounting acrobatics relating to deferred taxes. Since this has been billed as a simplified discussion, I will skip the details and give you the bottom line: $68.0 million was added to fixed assets and $13.0 million was eliminated from deferred tax liabilities. After making this $81.0 million adjustment, we were left with $24.3 million of premium to allocate.
Had our situation called for them two steps would next have been required: the adjustment of intangible assets other than Goodwill to current fair values, and the restatement of liabilities to current fair values, a requirement that typically affects only long-term debt and unfunded pension liabilities. In Scott Fetzer's case, however, neither of these steps was necessary.
The final accounting adjustment we needed to make, after recording fair market values for all assets and liabilities, was the assignment of the residual premium to Goodwill (technically known as "excess of cost over the fair value of net assets acquired"). This residual amounted to $24.3 million. Thus, the balance sheet of Scott Fetzer immediately before the acquisition, which is summarized below in column O, was transformed by the purchase into the balance sheet shown in column N. In real terms, both balance sheets depict the same assets and liabilities - but, as you can see, certain figures differ significantly.
The higher balance sheet figures shown in column N produce the lower income figures shown in column N of the earnings statement presented earlier. This is the result of the asset write-ups and of the fact that some of the written-up assets must be depreciated or amortized. The higher the asset figure, the higher the annual depreciation
or amortization charge to earnings must be. The charges that flowed to the earnings statement because of the balance sheet write-ups were numbered in the statement of earnings shown earlier:
- $4,979,000 for non-cash inventory costs resulting, primarily, from reductions that Scott Fetzer made in its inventories during 1986; charges of this kind are apt to be small or non-existent in future years.
- $5,054,000 for extra depreciation attributable to the write-up of fixed assets; a charge approximating this amount will probably be made annually for 12 more years.
- $595,000 for amortization of Goodwill; this charge will be made annually for 39 more years in a slightly larger amount because our purchase was made on January 6 and, therefore, the 1986 figure applies to only 98% of the year.
- $998,000 for deferred-tax acrobatics that are beyond my ability to explain briefly (or perhaps even non-briefly); a charge approximating this amount will probably be made annually for 12 more years.
It is important to understand that none of these newly-created accounting costs, totaling $11.6 million, are deductible for income tax purposes. The "new" Scott Fetzer pays exactly the same tax as the "old" Scott Fetzer would have, even though the GAAP earnings of the two entities differ greatly. And, in respect to operating earnings, that would be true in the future also. However, in the unlikely event that Scott Fetzer sells one of its businesses, the tax consequences to the "old" and "new" company might differ widely.
By the end of 1986 the difference between the net worth of the "old" and "new" Scott Fetzer had been reduced from $142.6 million to $131.0 million by means of the extra $11.6 million that was charged to earnings of the new entity. As the years go by, similar charges to earnings will cause most of the premium to disappear, and the two balance sheets will converge. However, the higher land values and most of the higher inventory values that were established on the new balance sheet will remain unless land is disposed of or inventory levels are further reduced.
See full PDF below.