Earnings season is upon us, as Wall Street chooses which companies to reward for a good quarter or punish for a bad quarter. Wall Street's obsession with earnings happens every quarter, the give and tug of who is rising versus the fallen. As value investors we don’t necessarily play this game; we are much more interested in the long-term outlook, as opposed to the short-term focus of earnings season.
Warren Buffett (Trades, Portfolio) eschews this mania and instead focuses on what he calls “owner earnings.” These earnings to him are a better representation of a company's true earnings.
This short-term focus that Wall Street has can cause a stock to rise or fall quite quickly, sometimes in the same day as the bears and bulls of each side of the trade rush in and out to try to get a better position. This volatility can be maddening and certainly test the wills of many.
Buffett rises above this madness and instead chooses to take a long-term approach that focuses more on the fundamentals of the business as opposed to the short-term earnings of one single quarter. These earnings on which everyone places so much focus can and have been manipulated before, sometimes to great effect.
Many investors have been blindsided by this manipulation and have lost a ton of money because of the greed and deceit of others. One way to avoid this is to do your research, and another is to adopt a long-term view that focuses on the fundamentals of the business and to see that management is doing the right things to grow it.
What are owner earnings?
In the 1986 Berkshire Annual Shareholder Letter Buffett outlined his thoughts on owner earnings.
“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 noncash 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.)”
Hubba, what? That was a mouthful, wasn’t it? OK, let’s break this down a little bit. I liken it to eating a pizza: You can’t eat it all at once, as much as you would like, but you can eat it one piece at a time.
Owners earnings =
- Plus reported earnings.
- Plus depreciation, amortization.
- Plus/minus other noncash charges.
- Minus average annual maintenance capex.
- Plus/minus changes in working capital.
Some of these terms are a little out of date, as he wrote this in 1986, and accounting rules have changed. There was far less information available then.
Let’s break this down a little bit more so we can make heads or tails of this equation.
Breaking down the owners earnings equation
- Reported earnings: This one is easy, as the net income comes from the income statement.
- Depreciation, depletion and amortization: Another easy one, found in the cash flow statement.
- Other noncash charges: Also found in the cash flow statement and includes any charges that don’t involve cash. A great example is employee stock compensation.
- Maintenance capital expenditure: Another easy one as this is in the cash flow statement as well although today we know it as the total capital expenditures. In 1986, statements of cash flows weren’t required which would have made it difficult to calculate what a capex was, let alone maintenance capital.
Buffett would have likely used averages to determine this number, but you and I have it easy. We can just use the total capital expenditures number.
Maintenance capex can be difficult to calculate accurately, and this could cause some inaccuracies in our calculations, which would throw off our numbers.
Far better to be conservative and use the total capex number than to underestimate the maintenance capex and pay more for a company.
- Working capital: “Working capital is defined as the difference between a company’s current assets and current liabilities. Working capital is a measure of a company’s short-term liquidity, or its ability to cover short-term liabilities.”
So changes in working capital can be defined as the net change in current assets and current liabilities.
A great way to illustrate this is:
- If the change in working capital is negative, that means working capital increased as the company needs more capital to grow.This reduces cash flow, and so it should reduce the owner earnings. (excluded in this case)
- If changes in working capital are positive, that means working capital decreased as the company has more cash for the company to grow and play with. This increases cash flow, and so it should add to owner earnings. (included in this case)
The above explanation is from one of my favs, Jae Jun from Old School Value.
Simply, this means that as assets grow and the company has more money to reinvest and grow, it will have more cash flow and this will grow owner earnings.
Why did Buffet create owner earnings?
When most investors look at the bottom line of the income statement, they see the net income; this is the profit that the company has generated for a particular period. Most people use that number to value a business or to calculate earnings per share just from the net income.
Buffett takes a different approach with his owner’s earnings. To understand how this works, let’s think about the possible paths that the net income can take after it’s produced.
The first path is a potential dividend payment, and any funds that go this route will be immediately considered owner earnings. The remaining balance of net income after the dividend payment is reinvested back into the business.
After the reinvestment, the money will also have two paths it could travel. The first path is to use the money to reinvest into the maintenance and care of the existing equipment. The second path is to spend the money to expand the assets of the business –Â i.e., buy more equipment.
If the funds flow in the first direction, called capital expenditures, the company’s book value will display little or no growth because it hasn’t done anything to grow the business. Maintaining the current equipment, while important, doesn’t grow the business.
If the funds flow in the second direction, the money will add new income streams to the company, and the new asset adds to the company's current equity. This second amount added to the dividend already paid out would be known as owner earnings.
Why go through all of this to find the value of a company? First, including the growth of current assets will increase the company's cash flow, which can be used to grow more assets or paid out as a dividend. If you simply use the net income to calculate earnings per share, then you are not taking into account what the company is doing with its cash, which is just as important as how it produces it.
As value investors, we are always looking for compounding machines to grow our wealth. Buffett was ahead of the curve, as usual, with his view on earnings and their treatment, which led to his creation of owner earnings.
Additionally, Buffett’s equation also looks at how the company treats its profit and what it chooses to do with it, which is another factor to consider when valuing a company.
Simply, this earnings equation is a deeper dive into the mindset of a company and how it treats its profit. As a shareholder, we want to know the amount of value the company is creating and how much is flowing back to us. This is what owner earnings are all about.
Owner earnings formula
Owner earnings = Net income + depreciation, amortization +/- other noncash charges – full capex +/- changes in working capital
For the most accurate, up-to-date numbers, it is recommended that you use the trailing 12-month numbers or TTM. To calculate this is fairly easy but takes a moment to look it all up.
Unfortunately, these numbers are not calculated on either the most recent 10k or the 10-q, so we will need to do these manually. You can get to your favorite financial web site and pull the numbers from there, but I like to do this manually. It gives me more control over the accuracy of the numbers.
We use the trailing 12-month (TTM) because the numbers from the 10k may be dated and the numbers would not be as up to date as we would like.
If you are feeling lazy, you can use the numbers from the latest annual report and just go with it.
However, if you would like to follow me on this journey, we will find the data for the TTM. To do this, we will simply use the rolling quarterly numbers for the last four quarters and add them up.
Pretty simple huh?
Walmart owner earnings example
For our example of Walmart (WMT, Financial), I am going to use the 10k information because it has not filed its first quarter 10-q so I can’t use the TTM to get the most recent data.
The lack of a TTM is OK because we want to be approximately correct instead of precisely wrong.
Before we get too far into the example using Walmart. I want to take a moment to talk about a few accounting ideas.
First would be the concept of current assets on the cash flow statement. For our purposes we are looking for a few specific items, such as accounts receivable and inventory. The definition of a current asset is something that can quickly be converted into cash or has liquidity.
The second item would be where to locate capex. It will be listed in the Cash from Investing Activities in the cash flow statement. Capex will usually be called “Purchase, plant and equipment (PP&E).”
Now onto the 10k
Using the figures from above in millions:
- Net Income = $14,293.
- Depreciation & Amortization = $10,080.
- Other non cash charges = $967.
o Deferred income taxes = $761.
o Other operating activities = $206.
- Capex = $10,619.
- Changes in working capital = $518.
o Current Assets = $619.
§ Receivables = -$402.
§ Inventories = $1,021.
o Current Liabilities = $1,137.
Now we will plug in the numbers and figure our the owner earnings for Walmart for the fiscal year 2016.
= 14,293 + 10,080 + 967 – 10,619 + 518.
= $15,239.
To find the owner earnings per share, we would simply divide this number by the diluted shares outstanding, which is found on the income line at the bottom of the statement.
In this case, there are 3,112 diluted shares outstanding. To follow through with the calculation of owner earnings per share, we divide the owner earnings by the diluted shares outstanding.
= 15,239 / 3,112.
= $4.89 owner earnings per share.
Now we can compare this to the stated earnings per share of the 10k which was $4.38.
That was fun. Let’s try another one, shall we?
Microsoft owner earnings example
As Microsoft (MSFT, Financial) reports its year ending in June 2016 we will need to calculate a TTM for it to get the most up-to-date information.
I am going to create a spreadsheet and pull the information together for you and show you how I did it.
Now that we have calculated the TTM for Microsoft we can finish our calculations for the owner earnings. All the data from above where from either the 10k or the 10q, which are quarterly earnings reports. I listed the dates from above for each report and the calculation was as follows.
Add latest annual report plus succeeding quarter reports minus preceding quarterly report by the nine months data to find the fourth-quarter data for our TTM.
We need to do this because the annual reports do not break out quarterly information.
So to plug our TTM numbers into our formula all numbers are millions unless otherwise stated.
= 17,813 + 8,345 + 2,177 – 8,501 -950.
= $18,884.
Now we can divide this by the diluted shares outstanding of 8,013 to get our owner earnings per share.
= $18,884 / 8,013.
= $2.36 owner earnings per share
Compare this to the $2.10 earnings per share on the most recent 10k.
In addition to the earnings per share comparison, we can also calculate a price to owner earnings which is very comparable to the very popular price-earnings (P/E).
So the price to owner earnings for Microsoft would be:
Current price = $68.81.
Owner earnings per share = $2.10.
Price to owner earnings = $68.81 / $2.10.
= 32.76.
You can compare this to the current P/E which is $30.32 per Gurufocus.com.
Final thoughts
Fun with numbers, right? As you can see Buffett was way ahead of the curve here; he has a different way of looking at things that make sense once you lay it out. His view on accounting and valuing businesses is legendary, and today’s lesson illustrates once again how simple yet insightful his thoughts are when it comes to finding value in a company.
One of the reasons I wanted to dig into this idea a little deeper is the troubling trend I see in analysts' intense focus on short-term earnings reports. I find the focus on the short term a little troubling because it leads to overreactions in the market, which can cause a ton of volatility among investors.
The other reason I wanted to look into this further is it helps illustrate a deeper look into the company's financials to give us a better picture of what is truly going on with the company, and how the decisions it makes can affect our investments. Earnings per share as presented in most analysts' reports is open to so much possible fraud and manipulation that it makes it difficult not to be skeptical.
I am not saying that all analyst reports are wrong or should be ignored. Far from it. I am saying they should be taken with a grain of salt. The possibility of fraud is there and should be investigated with a sharp eye to ensure that you don’t waste your hard-earned money because someone decided to be dishonest.
And to me, the use of a formula like owner earnings helps lessen that possibility because the items included in this formula are less prone to manipulation and can give you a truer number.
OK, I will get off my soapbox now, but I wanted to you to know the reason behind this post and how I think it could help you.
Our job when valuing a company is to determine its intrinsic value so we can apply a margin of safety to our investment. Correctly valuing a company is the only way to ensure if we do make a mistake that you are covered.
I hope you enjoyed this journey into the mind of a master and that you learned something valuable that will be able to help you in your investing journey.
I would love to hear your thoughts on this formula, and if you tried this out on any companies, you are interested in investigating. Drop me a line and let me know.
As always thank you for taking the time to read, I do appreciate it.
Take care,
Dave
Disclosure: The author is long Walmart and Microsoft.
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