After my post last week, Big spenders, Big value, as I was expecting, I got a few questions concerning the last part about Owner Earnings and valuation. As this topic couldn’t be summarized in a few sentences and as promised, here is a follow-up article which will hopefully provide you with answers to your questions. I don’t believe in over-complicated models and concepts, however this post is of course a bit more technical than others but will provide you with great insights. You need to keep it simple but once you understand a few concepts, you can only get better with time.
The idea of Owner Earnings was first introduced by Warren Buffett over 30 years ago in one of his famous shareholder letters. Since he started writing those letters, Buffett has enjoyed using them as a way to transmit some knowledge, which has been much appreciated from the investment community as he has often been ahead of the curve in terms of how to approach investing (and valuation). It’s always very refreshing to read Berkshire Hathaway’s shareholder letters as Buffett writes in a very direct, logical, and transparent manner, which contrasts with the standard fluffy and often misleading Chairman’s letters used to promote firms and explain why external factors are the cause of their own poor performance. I always find it unbelievable how some executive teams seem totally disconnected from the reality.
Let’s first consider how exactly Warren Buffett defined Owner Earnings in his 1986 shareholder letter.
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 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.”
– 1986 Berkshire Hathaway Inc. Shareholder Letter
Below, I focus on the Owner Earnings formula itself and break it down into pieces. I then follow up by presenting you how this formula can be improved further.
Owner Earnings =
(a) Reported earnings
+ (b) depreciation and amortization
+/- (b) other non-cash charges
+ (c) maintenance capex
+/- (c) changes in working capital
The different components can be defined as follows:
Reported earnings: This one is very straight forward and can be found directly at the bottom of the income statement. If you want to use the trailing twelve months (TTM) instead of the last annual report data you might need to do a few extra calculations. I would suggest you try to find the data directly at the source instead of using Google Finance, Yahoo Finance, etc. as sometimes there are mistakes in these websites’ calculations and you can gain much more insight from the actual annual report. One of the reasons why Price-to-Earnings ratio (as discussed previously) is so popular is that it’s extremely easy to find its numerator and denominator and even easier to calculate. However, I hope it is now slowly becoming apparent why it might not always be a good reference.
Depreciation and amortization: This number is also easy to find and can be found in the cash flow statement of the company. As this is a non-cash expense (so no real cash came out of the bank account due to this entry), we add it back to the reported earnings.
Other non-cash charges: As for depreciation and amortization, you will find the amount of other non-cash charges in the cash flow statement. These charges can be items such as deferred income taxes, etc. The logic for adding back these non-cash charges is the same as for depreciation and amortization.
Maintenance capex: This is clearly where the meat is! Simple but not easy as we say. First, what is maintenance capex? It basically is how much a company needs to spend every year in capital expenditure to maintain its competitive advantage, market position, and size. But not for growth. At the end of the day, the maintenance capex number is an estimate and is more art than science.
It can be very challenging to calculate maintenance capex as some companies need to keep growing (and spending) in order to maintain their competitive advantage and if this is the case then the expense becomes necessary and should be included as part of the maintenance capex – it requires some thinking and analysis. However, if for example, a company offers one main product and starts spending some capex dollars (or RMB, or EUR, etc.) in order to develop new divisions and services which are unrelated to the main product offered, then this should clearly not be included as maintenance capex.
On the other hand, if you are reviewing a very stable company which has been in operation for 50 years, the difference between its average capex number and its depreciation and amortization should be fairly small. If that’s the case, the maintenance capex number should be very close to the depreciation and amortization number.
Bruce Greenwald, who taught me during my time at Columbia Business School, suggests an interesting and very logical way of calculating maintenance capex.
Calculate the ratio of PPE [(property, plant, and equipment)] to sales for each of the five prior years and find the average. We use this to indicate the dollars of PPE it takes to support each dollar of sales. We then multiply this ratio by the growth (or decrease) in sales dollars the company has achieved in the current year. The result of that calculation is growth capex. We then subtract it from total capex to arrive at maintenance capex.
– Value Investing: From Graham to Buffet and beyond by Bruce Greenwald
This formula in itself is helpful to understand the concept of maintenance capex. And it is especially useful for stable companies with stable capex expenses. However, it can have its limitations when considering firms with highly volatile capex expenses and high growth companies.
Once again, you have to know what you know and what you don’t. If you have spent the last 15 years working in the chocolate production business, you probably have a good idea of what expenses are necessary to maintain the business and what is expensed for future growth – you have an edge.
Also, as maintenance capex is an estimate, you have the luxury to be on the more conservative or more aggressive side. As usual, unless you are an expert, I would recommend you to stay on the more conservative side of things and include a higher maintenance capex instead of a lower one.
Changes in working capital: In his definition of Owner Earnings, Buffett refers to “additional working capital [for the firm] to maintain its competitive position and unit volume”. What Buffett means here is basically that the level of working capital will have an impact on cash flow. If working capital, defined as “operating” current assets – “operating” current liabilities, increases from one year to another than it means that more cash is required to run the business operations of the firm and this increase should reduce the Owner Earnings. If you’re not familiar with the concept of changes in working capital or need more information, the following link is very useful. It provides an explanation and tons of examples.
If we stick to Buffett’s definition of Owner Earnings, that’s basically it, we’re done. However, things have evolved substantially in the last 30 years. Yes, even in accounting! And as discussed in my previous post (Big spenders, Big value), I would suggest to review the expenses of the firm (other than capital expenditures, such as R&D and advertisement expenses) and see if these expenses are necessary to maintain the current business as it is, including its long-term competitive advantage and scale. If these are not a necessity, you can consider adding them back to the reported earnings. So, growth-type of expenses should be added back – but be careful.
If you are looking at valuing a company, Owner Earnings represent the first step only. Don’t worry, there are only two main steps… This first step is useful not only in terms of finding a specific metric but in going through the calculations and understanding the business better. While going through the formula, you will come across items and concepts which will make you think further and which might have an important impact on your analysis. So, don’t just focus on finding an “answer”, keep your eyes (and mind) wide open.
I’ll have to leave the final step for a future post as a lot can be said about it. In the meantime, keep exploring the Owner Earnings concept!
Featured image: Well… you should know this guy. Source: newsrepublica.com
Embedded image: Bruce Greenwald – he is quite a character, believe me! Source: Forbes.com
Keep growing your snowball!
Next post, next week!
Much love,
– Alex Lanoie
