Owner earnings

Warren Buffett and Owner Earnings

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Owner earnings is introduced by Warren Buffett in 1986. Owner earnings is the cash that is available for the shareholders after capital expenditures. Here we see why this is so important and that many great businesses focus on available cash.

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Warren Buffett’s owner earnings

Buffett writes about the importance of owner earnings in the letter to shareholders of 1986. He uses this concept to explain the number of earnings shareholders get from the company Scott Fetzer (a manufacturer that Berkshire bought).

Owner earnings 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).

Warren Buffett, 1986

Cash flow should include capital expenditures

In sum, Buffett states that the real free cash flow is the cash flow (a + b) minus capital expenditures (CAPEX). Capital expenditures (or plant, property and equipment expenditures) can be higher or lower than the amount of depreciation. He mentions an example of oil companies who often spent more than their depreciation charges. Wall Street often reports only the cash flow without subtracting capital expenditures. Just look at the amount of EBITDA in reports, which does not include CAPEX. This can give a false presentation of the available cash to shareholders.

Cash flow is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, (c) (CAPEX) is always significant.

Warren Buffett, 1986

Cash flow and capital expenditures

CAPEX is reported on the balance sheet to the assets (e.g. a new machine). This means that these costs are not deducted from the profit and loss statement. Growing earnings can be the result of large CAPEX spending. Essentially, large capital investments are needed for sales growth. But the costs of this growth can be higher than the profit (net income).

This means that no real money is available for the shareholders! Hence the need for the investor to check the profit and loss and the cash flow statement. The cash flow statement reveals the Operational Cash Flow and the CAPEX. Subtracting CAPEX from the Operational Cash Flow gives the Free Cash Flow.

Capex needs differ by industry

As stated in a previous article, capital expenditures are necessary for maintenance and growth. For airlines and industrials, CAPEX is crucial. For other companies like cigarette manufactures, CAPEX will be relatively small. Coca Cola also has a relatively small CAPEX needs compared to their operational cash flow.

Hence, they don’t spend a lot of money on their machines to make sure they can generate the same revenue. A rule of thumb is seeing whether the CAPEX is less than half of the operating cash flow (CAPEX / Cash Flow < 50%). A good business can finance its capital assets with its free cash flow and not by adding continuously more debt and equity to grow. Obviously, there are exceptions when raising more debt and equity can be a good idea. For example if the share price is very high or if there is a tax shield opportunity. Another reason could be a very good investment that can’t be financed with the free cash flow and available liquidity.

Amazon’s focus on free cash flow

Many good businesses focus on Free Cash Flow (FCF) instead of yearly earnings. Jeff Bezos (CEO of Amazon) gives a great explanation in the annual report of 2004 about free cash flow and its importance.

Why not focus first and foremost, as many do, on earnings, earnings per share or earnings growth? The simple answer is that earnings don’t directly translate into cash flows, and shares are worth only the present value of their future cash flows, not the present value of their future earnings.

Jeff Bezos

Jeff Bezos is a business owner and understands that the cash that is available is what ultimately counts. The value of a stock is determined by estimating the amount of cash that the business will generate in the future. The value of this future cash flow today is determined by using the discounted cash flow analysis (DCF).

CEO’s of companies who focus a lot on adjusted earnings and earnings before depreciation should be analyzed with extra care. A general assumption would be that capital expenditures (costs for machines, property and equipment) are not subtracted from the operational cash flow as this would reveal an unsatisfactory result.

Apple’s Free Cash Flow example

Let’s look at a real example of a cash flow statement from the annual report of Apple to determine the free cash flow. The cash flow statement has 3 main parts:

  1. Operating activities (describes how much cash the business generates with its core business)
  2. Investing activities (lists mainly investments in CAPEX and securities (other investments)
  3. Financing activities (shows debt changes, dividends and stock repurchases)

Here we focus on part 1 (operating activities) and the CAPEX (payments for acquisition of property, plant and equipment) that can be found on part 2 (investing activities).

Apple Annual Report 2019 Cash Flow Statement
Apple’s Cash Flow Statement Annual Report 2019

Apple’s Free Cash Flow

We take the net income from the profit and loss statement and adjust for cash and non-cash expenditures. Depreciation and amortization are added back as they represent earlier cash outlays for machines and goodwill. Accounting rules state that due to the longer life of most assets, a business can deduct the costs over e.g. 10 years from the earnings. This depends on the type of asset and how long it lasts.

A building will last longer than a machine. Amortization is similar to depreciation, but is used for intangible assets like goodwill. This is often the result of acquisitions.

So, a machine of $10,000 causes a decrease in earnings of $1000 per year for 10 years. The yearly $1000 is no longer a cash outlay, hence added back on the cash flow statement.

Changes in operating (or current) assets and liabilities means changes in the working capital. Simply said, does the business require more cash to operate compared to last year? Decreasing accounts receivable and lower inventory means more cash and vice versa. I’m ignoring the other items like stock compensation (you could argue that this is a cost) for simplicity.

Apple’s operating activities generated a cash flow of $69,391 million. The next step is to check the CAPEX, we see that this is $10,495 million. This leads to a Free Cash Flow of $58,896 million (Cash flow from operations minus CAPEX). The Free Cash Flow is the money that is available to buy back stocks, pay dividends or to make acquisitions. Apple has a very healthy Free Cash Flow track record.

Owner earnings conclusion

Owner earnings is the cash generated by the operations of the business minus the capital requirements. Owner earnings is similar to the Free Cash Flow. Although ideally, you want to separate capex in a maintenance and growth part. As growth CAPEX can lead to additional production capacity.

Focusing on businesses that have a healthy free cash flow will help to reducing investment risk. Ultimately, the Free Cash Flow will determine the value of the business and is used in the DCF analysis.

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