In Warren Buffett’s 1986 shareholder letter, he discussed a concept known as owner’s earnings. Here is what he had to say:
"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.)
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.”
I’m currently working on a comprehensive guide to income statement analysis (as laid out by Ben Graham), which should help us with this exercise; however, choosing which “certain other non-cash charges” (like Buffett’s items 1-4 from above) to include is unclear. This article will look at Ben Graham’s discussion on Cash Flow Analysis in "Security Analysis", which should shed some light on this subject.
Graham suggests following the cash-to-cash cycle of the typical business in order to understand the cash flow concept; this starts with sales (or accounts receivable), which “can be used as the first approximation of the actual cash received from operations.” This progression can be generally followed through the revenues and expenses in the income statement. Importantly, as noted by Graham, “the primary use of the funds statement [cash flow statement] is to confirm or deny, over time, the amounts shown in the income statement.” By taking the numbers in an accrual basis on the income statement and adjusting them to a cash basis, we can create a cash basis income statement, which is a better measurement for the equity investor in valuation than GAAP earnings.
Graham suggests that the investor starts by calculating operating cash flow, which can be compared with operating income; operating cash flow is calculated as such:
(1) Revenues
(-/+) Increase/Decrease in Account Receivable
+ Interest Income
- Noncash Interest income
+ Amortization of Bond Premium
+ Dividends from Equity Investments
+ Foreign Currency Gain
= TOTAL CASH INFLOWS FROM OPERATIONS
(2) SG&A expenses
+ COGS
(+/-) Increase/Decrease in Inventories
(-/+) Increase/Decrease in Account Payable
(+/-) Increase/Decrease in Prepaid Expenses
(-/+) Increase/Decrease in Accrued Liabilities
(+/-) Increase/Decrease in Other Noncash, Nontax Current Assets
+ Cash Foreign Currency Translation Loss
= TOTAL CASH OUTFLOW,
Where net cash flow from operations (before interest/income taxes) = (1) INFLOWS – (2) OUTFLOWS
After adjusting for interest costs and income tax expense, we are left with cash flows from operations that can be used for dividends/repurchases, capex, and debt repayment.
For investing activities, Graham suggests simply taking purchases of plant and equipment and subtracting dispositions to calculate to investment. In regards to capital expenditures, Graham says little that can help us to breakdown the capex issue of maintenance versus growth — he suggests asking, “Did the capital expenditure improve earnings power, hold it at the original level, or were they so inadequate as to permit earning power to decline?” However, this does little to answer the question of what amount is representative of an increase in the capital base, instead answering how effective it was. As Buffett notes, this number must be a guess; as always, the intelligent investor errs to the conservative side with his/her estimate of this figure.
Financing activities, such as retirement of debt, are self-explanatory and immediate uses of cash; from here, we can sum up the line items and calculate the cash flow for the period as such:
Cash flows from operations – investments – financing – dividends paid = net increase in cash/equivalents
As Graham notes, “Ideally, this number will turn out to be precisely equal to the change in cash and equivalent shown on the balance sheet, but that seldom happens.” He suggests that income estimated from cash flows should be the sum of the increase in cash items, dividends paid, growth capex, and other increases in working capital, less net financing. Using the framework laid out in "Security Analysis" can help the investor cover all adjustments that might be needed to achieve cash numbers from an accrual basis, which are “more reliable numbers, more understandable numbers.”
"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.)
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.”
I’m currently working on a comprehensive guide to income statement analysis (as laid out by Ben Graham), which should help us with this exercise; however, choosing which “certain other non-cash charges” (like Buffett’s items 1-4 from above) to include is unclear. This article will look at Ben Graham’s discussion on Cash Flow Analysis in "Security Analysis", which should shed some light on this subject.
Graham suggests following the cash-to-cash cycle of the typical business in order to understand the cash flow concept; this starts with sales (or accounts receivable), which “can be used as the first approximation of the actual cash received from operations.” This progression can be generally followed through the revenues and expenses in the income statement. Importantly, as noted by Graham, “the primary use of the funds statement [cash flow statement] is to confirm or deny, over time, the amounts shown in the income statement.” By taking the numbers in an accrual basis on the income statement and adjusting them to a cash basis, we can create a cash basis income statement, which is a better measurement for the equity investor in valuation than GAAP earnings.
Graham suggests that the investor starts by calculating operating cash flow, which can be compared with operating income; operating cash flow is calculated as such:
(1) Revenues
(-/+) Increase/Decrease in Account Receivable
+ Interest Income
- Noncash Interest income
+ Amortization of Bond Premium
+ Dividends from Equity Investments
+ Foreign Currency Gain
= TOTAL CASH INFLOWS FROM OPERATIONS
(2) SG&A expenses
+ COGS
(+/-) Increase/Decrease in Inventories
(-/+) Increase/Decrease in Account Payable
(+/-) Increase/Decrease in Prepaid Expenses
(-/+) Increase/Decrease in Accrued Liabilities
(+/-) Increase/Decrease in Other Noncash, Nontax Current Assets
+ Cash Foreign Currency Translation Loss
= TOTAL CASH OUTFLOW,
Where net cash flow from operations (before interest/income taxes) = (1) INFLOWS – (2) OUTFLOWS
After adjusting for interest costs and income tax expense, we are left with cash flows from operations that can be used for dividends/repurchases, capex, and debt repayment.
For investing activities, Graham suggests simply taking purchases of plant and equipment and subtracting dispositions to calculate to investment. In regards to capital expenditures, Graham says little that can help us to breakdown the capex issue of maintenance versus growth — he suggests asking, “Did the capital expenditure improve earnings power, hold it at the original level, or were they so inadequate as to permit earning power to decline?” However, this does little to answer the question of what amount is representative of an increase in the capital base, instead answering how effective it was. As Buffett notes, this number must be a guess; as always, the intelligent investor errs to the conservative side with his/her estimate of this figure.
Financing activities, such as retirement of debt, are self-explanatory and immediate uses of cash; from here, we can sum up the line items and calculate the cash flow for the period as such:
Cash flows from operations – investments – financing – dividends paid = net increase in cash/equivalents
As Graham notes, “Ideally, this number will turn out to be precisely equal to the change in cash and equivalent shown on the balance sheet, but that seldom happens.” He suggests that income estimated from cash flows should be the sum of the increase in cash items, dividends paid, growth capex, and other increases in working capital, less net financing. Using the framework laid out in "Security Analysis" can help the investor cover all adjustments that might be needed to achieve cash numbers from an accrual basis, which are “more reliable numbers, more understandable numbers.”
