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Using Mr. Buffett’s Ratio in Analyzing Guru Portfolios

Many years ago while reading the Berkshire Hathaway (BRK.A) 1986 letter to shareholders, I discovered Mr. Buffett’s ratio, which he calls "Owner Earnings". And to my amazement, in that little footnote Mr. Buffett actually explains how to use it and basically states that it is one of the key ratios that he and Charlie Munger use in analyzing stocks. In that he defined the term “owner earnings” as the cash that is generated by the business operations, regardless of the earnings the company reports to Wall Street. Mr. Buffett: “…we consider the owner earnings figure, not the GAAP [earnings] figure, to be the relevant item for valuation purposes-both for investors in buying stocks and for managers in buying entire businesses.”

“[Owner earnings] 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.”

From this I have spent the last few decades creating and back testing three ratios that incorporate owner earnings in my quantitative analysis of companies and they are:

1) Price to Owner Earnings

2) FROIC

3) CapFlow

Price to Owner Earnings (my own version of Price to Free Cash Flow)

Price per share/(cash flow per share-capital spending per share)

I have back tested this ratio on the DJIA going back 60 years and you can find my research paper on it by going here.

I was able to determine in my back test that buying a stock selling for 15 times or less its Price to Owner Earnings, increases the probability of success dramatically in most cases.

FROIC is basically Free Cash Flow Return on Invested Capital or:

(Cash Flow - Capital Spending)/(Long Term Debt + Shareholder’s Equity)

I look for companies that achieve “Owner Earnings” returns of at least 15% on Main Street for every $1 of “Total Capital Invested”. Basically in the real world of Main Street, far from Wall Street companies that achieve 15%+ on this ratio are making a lot of money, so logically if you have a business whose cash register if overflowing continuously, there is a great probability of making some serious money someday.

The third ratio that I use to pick stocks I call “CapFlow”. CapFlow is basically:

Capital Spending/Cash Flow

This ratio allows me to identify elite management teams that achieve very low costs in relation to their cash flow. Very simply they are usually the low cost producer in their industry because of their managements great attention to detail in their cost control management. They also use things like “Economies of Scale”, where as their sales increase their cost per unit decreases.

So to summarize we search for the following ideal for each ratio;

1) CapFlow = less than 50%

2) FROIC = greater than 15%

3) Price to Owner Earnings = less than 15

We then generate a final score based on how a company performs on each of these ratios. The final scores range from zero to three.

Zero = a company that fails on each ratio

Three = a company that scores perfectly

If you can put a portfolio together with a large number of three’s in it, that will allow you to basically get a portfolio of companies that are performing very well on Main Street, but are also strong value/growth plays on Wall Street.

Here are three companies for example that currently score perfectly on my system:



Once I find a company scoring well on my system, I then go and do a Philip A. Fisher qualitative analysis. For those of you unfamiliar with Mr. Fisher here is a link that will give you an introduction to the master. FROIC and CapFlow are ratios that I designed to test management effectiveness and if you do a long term analysis of a company using my system, you can see a pattern of consistency, which was what Mr. Fisher looked for first. I can demonstrate this by giving you a long term owner earnings analysis of Apple (AAPL) from 1995-2012.



[img]file:///C:/Users/MYCROF%7E1/AppData/Local/Temp/msohtmlclip1/01/clip_image001.jpg[/img]

As you can see from the table above that had you invested in Apple when it first hit a “three” in 2009, your return would have been excellent.

My system also works very well in analyzing entire industries or Guru's portfolios (ETF, Hedge and Mutual Funds etc..) and within minutes allows you to separate the super stocks from the dogs with fleas. Here is an analysis of the Toiletries and Cosmetics Industry:



From the data above you can see quite clearly that Regis Corp.(RGS) is the weakest player and that Estee Lauder (EL) and Nu-Skin Enterprises (NUS) are the strongest. Unfortunately Estee Lauder can hardly be considered a value play with a price to owner earnings of 25.93, but Nu-Skin sure shows promise. I can tell this by using FROIC, which is the most powerful ratio in investment analysis as far as I am concerned, as it really tells us how much in owner earnings are being created for every $1 of total capital employed. It is a real laser beam to what is really happening on Main Street. When your portfolio is full of strong FROIC's you can really amass some amazing gains on Wall Street.

Here is a long term chart of Avon Products (AVP)



Now here is the FROIC data to help us to analyze Avon Products from 1974-2012:



As you can see from 1990 to 2008 Avon Products was an amazing performer, but like all great companies sometimes they stumble and create opportunity for value investors. In 2009 the FROIC for Avon not only fell -55.53% but it also broke below 15% as owner earnings growth also started to stumble. From 1998 to 2005 the company was just super on Main Street and that clearly showed up on Wall Street.

So if we are going to start analyzing Guru Portfolios in our GuruFocus articles, we should at least start out by analyzing the portfolio of the person who first gave us the ratio that I have built a complete system around. Here is Warren Buffett’s current portfolio analyzed using owner earnings:



As you can see from the table above that Mr. Buffett obviously still uses his owner earnings formula as his most recent purchases IBM (IBM) and Intel (INTC) score very high on my system. You will also notice that his retail positions are not ranking very well, which may be a sign that owning that industry right now might not be the smartest thing to do. Oil companies are also not doing very well on Main Street in my research and if it wasn’t for the problems with Iran, I think oil would have been trading around $70 a barrel, as the entire industry has terrible CapFlows. CapFlow is an early indicator of problems on Main Street. When it deteriorates it does so slowly in most cases, so it gives the investor a heads up on what’s coming down the road. You will notice that I don’t include Berkshire Hathaway’s (BRK-A) financials holdings as owner earnings cannot be analyzed using it. Don’t feel bad though as this would have kept you out of Bank stocks over the last five years and you would have avoided the nightmare returns that some Gurus have, who invested heavily in them.

For those who want to analyze them just replace cash flow with earnings per share, use zero for capital spending and use ROIC instead of FROIC and PE instead of P/OE. Disclaimer: Always remember that these are the results of our research based on the methodology that I have outlined above and in other articles previously published. This research is provided as an educational tool and should not be considered investment advice, but just the results of our research. There are many ways to analyze a stock and you should never blindly follow anyone’s work without doing your own due diligence or by seeking the help of an investment advisor, if you so need one. As Registered Investment Advisors, we see it as our responsibility to advise the following: We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong. Please note, investments involve risk and unless otherwise stated, are not guaranteed. Past performance cannot be used as an indicator to determine future results. Strategies mentioned may not be suitable for everyone. We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice. Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for you. Before acting on any information mentioned, it is recommended to seek advice from a qualified tax or investment adviser to determine whether it is suitable for your specific situation.

About the author:

Mycroft Psaras
Mycroft has spent most of his life as an equity analyst studying the works of the masters. He is an expert in Qualitative and well as Quantitative investing and lives by the motto of “Capital Appreciation through Capital Preservation”. He has worked as an advisor for friends and family and worked for The Motley Fool Organization for a while. Prior to starting Mycroft Research, he spent the last decade writing investment newsletters and providing research to a large following of clients.

From his work on free cash flow in the investment process, Mycroft has now decided to bring his theories to the field of money management as well as work as an independent consultant for Hedge Funds, Pension Funds and ...More Institutions in general. His dream is to someday soon open a mutual fund where he can help as many people as he can benefit from what he has learned over the years.



Visit Mycroft Psaras's Website


Rating: 4.2/5 (49 votes)

Comments

Adib Motiwala
Adib Motiwala - 2 years ago
Good stuff. Thanks for posting. A question: For capital spending, are you taking entire capex or trying to differentiate maintenance and growth capex?
mycroftpsaras
Mycroftpsaras - 2 years ago
Hi Adib,

I use the numbers that Value Line generates. I analyze over 7000 stocks looking for that super long or super short so thank God for Value Line. I also like to look at what the Guru's are buying here on this site because I have heard that the first thing that Warren Buffett asks when he talks to Analysts and Portfolio Managers is "What are you buying". So GuruFocus does that job for me and I love it!

Regards,

Mycroft
batbeer2
Batbeer2 premium member - 2 years ago
Hi Mycroftpsaras,

Thanks for the interesting article.

How would Berkshire Hathaway rank on this list ?

mycroftpsaras
Mycroftpsaras - 2 years ago
Hi Batbeer2,

You can't really analyze Berkshire Hathaway with this system as you can't do a CapFlow analysis on it. Berkshire Hathaway has a Return on Invested Capital (ROIC) estimate of 5.48% for 2012 and a forward P/E of 14.47, so I would consider it fairly valued. If I were to grade it I would give it a 2 out of 3.

Mycroft
batbeer2
Batbeer2 premium member - 2 years ago
Thanks for the response.

I take it the CapFlow analysis is not possible because Cashflow and Capital spending as reported are not meaningful or is there some other reason I'm missing ?
gurulands
Gurulands premium member - 2 years ago
Hi Mycroft,

Great article!

Could you perform the calculations that go into each of the three ratios in detail on a company to show how the calculations are performed?

I would like to learn how to perform these calculations.

Thanks for the great article!

solomon78
Solomon78 - 2 years ago
Mycroft,

Great article.

1. Where can I find the Capital Spending in the financial statements. Is it a calculation or can I find it on the financial statements.

2. Because Buffet likes to look at least 10 years of their financial statement to determine the potential of a company, so must I determine these ratios for 10 years or is it the current year which will help me determine it's true potential in the coming years.

3. What is the main difference b/n P/E vs Price to owner Earnings; and FROIC vs ROIC.

Thank you in advance for your clarification.

Solomon
ken_hoang
Ken_hoang - 2 years ago
HI Mycroft,

Great article. Thanks for posting this. The Value Line number post the whole capex figures in. Sometimes the effect of huge capex used this year will be reflected in the performance a few years later. So the listings of the ratio of more than 10 years really help.Thanks again.
jrossi
Jrossi - 2 years ago
Well done. Cheap companies that don't require much capital investment with good ROC. Any data for Microsoft? thanks.
Bogman
Bogman - 2 years ago
Outstanding article, good metrics.
gs271
Gs271 - 2 years ago
Nice stuff, the historical returns are indeed remarkable!

Please do show us how you exactly calculate your version of owner earnings :

owner earnings = cashflow - capex ?

so do you mean operating cash flow - capex? or what exactly do you define as cash flow, the overall cash flow? because that would already include capex (cashflow from investments)?

I do understand the way Warren Buffett does it,

Net Profit + Non cash charges - Average maintenance capex

I dont quite understand yours though : )

Thanks for explaning!! best regards.
mycroftpsaras
Mycroftpsaras - 2 years ago
Hi Gurulands,

Here is an analysis of 3m (MMM)

If you are going to use this analysis always go to the furthest year out so calculate 2012 this way:

www3.valueline.com/dow30/f5993.pdf

Step #1

Cash Flow per share - Capital Spending per share = Owner Earnings per share

So for 2012 we get $8.90 - $2.25 = $6.65

Today's Price = $83.37

So $83.37/$6.65 = 12.536 and that is your price to owner earnings.

To calculate CapFlow you take

$2.25/$6.65 = 33.8%

To Calculate FROIC

Owners Earnings per share / Total Capital per share

Total Capital per share = ((Long term debt + Shareholders Equity)/ (shares outstanding))

So for 2012 we get

$6.65/ ((3415+20990)/702

$6.65 = Owner Earnings

$24405 = Total Capital Employed

702 = millions of shares

$6.65/ (24405)/(702)

$6.65/$34.76 = 19.13% = FROIC

Good Luck,

Mycroft
mycroftpsaras
Mycroftpsaras - 2 years ago
Hi Solomon78,

Just go to the Value Line link listed in my previous post and download all 30 DJIA companies for free.

There you will find at least 10 years of data.

If you go to the cash flow statement for any non-financial you will find a listing called "Investments in Property, Plant and Equipment" and that's your capital spending.

http://financials.morningstar.com/cash-flow/cf.html?t=LINTA®ion=USA&culture=en-us

As you can see by going to the bottom of that page that Morningstar verify's that fact.

PE is a 19th century took and is outdated as it just factors in earnings.

P/OE is the same calculation but uses owners earnings instead which is cash flow -capital spending.

It allows you to see what management is up to because if they are big spenders and terrible at managing your costs you will know about it right away. That's why Buffett never gets fooled.

ROIC is the same thing as its just earnings to total capital.

What I want to know is when you factor in capital spending how much is left and that's what FROIC tells you. If your pizza place earns $50 in earnings for every $100 in total capital employed you are doing great. But not if you have to spend $110 in capital improvements. FROIC picks that up while ROIC does not, Oil companies are perfect example of this as they are reinvesting most of their profits in capital improvement and thus just running in place instead of growing.

Good Luck,

Mycroft
mycroftpsaras
Mycroftpsaras - 2 years ago
Hi Ken_hoang

Value line is the ultimate tool and I would be no where with out it [/u]Mycroft [u]
mycroftpsaras
Mycroftpsaras - 2 years ago
Hi JRossi,

Just go to an earlier post of mine and go to the Value Line link that will give you Microsft's sheet for free and you can easily then do a 10 year analysis.

Good Luck,

Mycroft
mycroftpsaras
Mycroftpsaras - 2 years ago
Hi Gs271

Just go to the post I made for Gurulands and all the data you need is there. Just use the Value Line sheets and you will understand what I do.

Good Luck,

Mycroft

[url=http://www.gurufocus.com/../ic/space.php?uid=121167][/url]
gurulands
Gurulands premium member - 2 years ago


Hi Mycroft,

Did your backtest include dividends; and, if so, were the dividends reinvested?

Also, thanks for taking the time to explain each of the three calculations for us.
mycroftpsaras
Mycroftpsaras - 2 years ago
Hi Gurulands,

Yes the dividends were included and reinvested.

Mycroft
jrossi
Jrossi - 2 years ago
Hi Mycroft,

In your analysis of 3M, it looks as if you used owner earnings/share ($6.65) instead of cash flow/share ($8.90) for the denominator when you calculated CapFlow. Is this how you do it? Thanks again for the article. JRossi
mycroftpsaras
Mycroftpsaras - 2 years ago
Hi Jrossi,

I took the cash flow per share of $8.90 and subtracted the capital spending of $2.25 and I got an owner earnings of $6.65.

Hope that helps,

Mycroft
jrossi
Jrossi - 2 years ago
Hi Mycroft, Yes I get that, but it seems as if, in your article, you used cash flow, not owner earnings, as the denominator when calculating CapFlow. I'm just wondering which one you use. Thanks again. Jrossi
mycroftpsaras
Mycroftpsaras - 2 years ago
Oh I am sorry Jrossi the hour is late.

To figure out CapFlow you take capital spending and divide it by cash flow.

capital spending/cash flow

This is a qualitative ratio that I created to help one determine how good the cost controls of management are. below 50% is what you are looking for.

Sorry about that, have a great night,

Mycroft
jrossi
Jrossi - 2 years ago
Mycroft,

Thanks again. Terrific article, easily the most useful I have ever read at gurufocus and one the best value investing articles I have ever read, period. Take care, JRossi
zwiphy
Zwiphy - 2 years ago
Hi mycroft,

nice article!

I was wondering, Why don't you take Enterprise value/(owner earnings + interest expense) ?

That way you can compare companies with different debt levels.

Nice idea, the capflow!
mycroftpsaras
Mycroftpsaras - 2 years ago
Hi Zwiphy,

I am old school and since I first read about owner earnings decades ago I have just stuck to that. If something works very well, why should I change it? Not to say that your system would not work just as well, but I have decades of data going back to 1969 so I am too old to start over again. I am firmly set in my ways now.and sleep like a baby every night :-) Not many people in my line of work can say that and like Buffett I skip to work everyday :-)

Warm Regards,

Mycroft

gurulands
Gurulands premium member - 2 years ago


Hi Mycroft,

I saw where you are looking at 7,000 stocks in your universe; however, when I go to Value Line I don't see a service with 7,000 stocks in it. Are you subscribing to a multitude of services?

Isn't this same info available on GuruFocus? At least the info you used for the three calculations you performed here.
mycroftpsaras
Mycroftpsaras - 2 years ago
Value Line actually has 7000 stocks in it when you combine their Small & MidCap with the large cap. They don't publish 7000 reports but I have data going back as far as 1969 on 7000 stocks.

I also use GuruFocus and Morningstar as well.

Mycroft
aldandrea
Aldandrea premium member - 2 years ago
Outstanding article, thank you!

It would be nice to see this calculated for each stock as part of the gurufocus.com site, no?

Also, did anyone get a result for Microsoft yet?

Al
mycroftpsaras
Mycroftpsaras - 2 years ago
Hi Aldandrea,

Microsoft is the largest holding of Wally Weitz and Microsoft was analyzed here:

http://www.gurufocus.com/news/158174/wally-weitzs-portfolio--buffett-ratio-guru-portfolio-analysis

Thanks for the kind words,

Mycroft
Bertrand
Bertrand premium member - 2 years ago


Dear Mycroft,

Thank you for an insightful and informative article.

Can you pls be so kind to clarify for the definition of CapFlow.

You state it is Capital expenditures / Cash Flow.

In the denominator which "cashflow" are you referring to ? Free Cash Flow, Operating Cash Flow, or EBITDA ?

Thank you

Bertrand

P.S: Also a big fan of the Psaras ratio !

mycroftpsaras
Mycroftpsaras - 2 years ago
Hi Bertrand,

The Psaras ratio, wow you go back over a decade on that one don't you :-)

Cash Flow is basically just Net Income + Depreciation and Amortization.

I try to keep it simple as simple works best. I don't calculate it myself but work exclusively from Value Line and use their Capital Spending Per Share/ Cash Flow Per Share.

I have been doing this for decades so I know it works and my backtest of the DJIA from 1950-2009 verifies that it works.

Warm Regards,

Mycroft
Harney246
Harney246 premium member - 2 years ago


Mycroft:

Thank you!

I am confused about your 3M example, as I do not arrive at the same numbers as you quote.

Step #1

You said: “Cash Flow per share - Capital Spending per share = Owner Earnings per share

So for 2012 we get $8.90 - $2.25 = $6.65

Today's Price = $83.37

So $83.37/$6.65 = 12.536, and that is your price to owner earnings.” Reply:

Value Line is showing in 2012 Column:

$8.35 for “Cash Flow” per share and $2.20 in Capital Spending Per Share. This results in

$8.35 –$ 2.20 =$ 6.15

Using Price/ Owners Earnings:

83.37 / 6.15 = 13.556 not 12.536

Step #2

You said: “To calculate CapFlow you take $2.25/$6.65 = 33.8%” Reply:

Capital Spending / Owners Earnings

Adjusted CapFlow Rate is 2.20 / 6.15 = 35.77%

Later, you said:

To figure out CapFlow you take capital spending and divide it by cash flow.

capital spending/cash flow. Reply:

2.20 / 8.35 = 26.3%

Step #3

You said: To Calculate FROIC

Owners Earnings per share / Total Capital per share

Total Capital per share = ((Long-term debt term debt + Shareholders Equity)/ (shares outstanding))

So for 2012 we get

$6.65/ ((3415+20990)/702

$6.65 = Owner Earnings

$24405 = Total Capital Employed

702 = millions of shares

$6.65/ (24405)/(702)

$6.65/$34.76 = 19.13% = FROIC Reply:

Owners Earnings / Total Capital per Share

Total Capital per Share = (4485 + 19585) / (695) = 34.63

6.15/ 34.63 = 17.76% =FROIC

To show my work, I am hyperlinking to my highlighted Value Line MMM attachment.



https://skydrive.live.com/redir.aspx?cid=ea8d34d1aae79c82&resid=EA8D34D1AAE79C82!3015&parid=EA8D34D1AAE79C82!3014

Regards,

Tom

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