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Geoff Gannon Investor Questions Podcast #7: Does Warren Buffett Use Pre-Tax Earnings or Free Cash Flow to Value a Stock?

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Geoff Gannon
Mar 11, 2010
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The book we’re talking about here is called Buffettology. It was written by Mary Buffett. She’s Warren Buffett ’s ex daughter-in-law. And she wrote two books: one called Buffettology and another called The New Buffettoloy. Flipping through them both I found more stuff in the first Buffettology that had to do with what we’re talking about here.

So I’ll be quoting more from that book than from The New Buffettology.


Listen to the show

The first thing I want to say is that Buffettology and The New Buffettology are not bad books. I’m going to be beating up on Mary Buffett in today’s show because I want to answer the question that was asked. And that question has to do with pre-tax earnings and free cash flow. Mary Buffett does a terrible job of explaining free cash flow and what it means to Warren. Instead she completely ignores free cash flow - and pretends he uses earnings per share.

He doesn’t. And I think she knows that. But she wanted to keep the book simple. I think that was a mistake.

But overall I think both books are worth reading. If you haven’t read them - you should go out and get them today. They do a better job of explaining Buffett’s approach to stockpicking than most of the books out there. And while some people don’t like that Mary Buffet cashed in on the fact she used to be Warren’s daughter-in-law - I think investors should put motives aside and just buy the best books out there. And when it comes to Warren Buffett - the two books Mary Buffett wrote are more useful than a dozen of books written by investment writers who give you their approach to stock picking and call it Warren Buffett’s. At least Mary Buffett tried to explain Warren’s approach in a simple, straight-forward way. And for that reason you should read her books.

Okay. Now that the compliments are out of the way - why don’t I try answering the question. First: I totally understand why you felt Mary Buffett was saying that Warren uses pre-tax earnings instead of free cash flow to value a stock. She never uses the words “free cash flow” anywhere in her book.

But if you read between the lines - you’ll see she’s actually talking about free cash flow most of the time.

On page 41 of Buffettology she writes:

“He takes the yearly per share earnings and treats them as the return that he is getting for his investment. So if a company is earning $5 and the shares are selling for $25 a share, Warren perceives this as getting a 20% return on his money for the year…The $5 can either be paid out by the company by way of a dividend or be retained and utilized by the business to maintain or expand operations.”

See how she never uses the words “free cash flow”. But she says that the earnings can be paid out in a dividend or the company can keep the earnings and use them to grow the business.

Now think about that for a second. Is it true? Can a company really pay out its earnings in a dividend?

No. Dividends are paid in cash. The only way a business can pay a dividend is if it has cash. Look at railroads if you want proof. No railroad can pay out 100% of its earnings in a dividend unless it takes on a lot of debt. About half of a railroad’s reported earnings have to be plowed back into the business just to keep the railroad going.

Buffett has talked about this very issue in the last few months. Ever since buying Burlington Northern - Buffett has been saying that Berkshire will have to put a lot of money back into the railroad. He’s made it clear that Berkshire can not take all of Burlington’s earnings and use them on other things. A lot of those earnings have to stay in the business because they don’t come in the form of free cash flow.

Mary Buffett makes this point clear later on. For example: on page 107 she has a section titled “Does the Business Get to Retain its Earnings” and another one called “How Much Does the Business Have to Spend on Maintaining Current Operations”.

Both of these sections are about free cash flow. But you’re right. She doesn’t actually use the words “free cash flow” when writing about these things.

On the next page she tells a story about Warren that makes it very clear he uses free cash flow instead of earnings to value a business.

She writes:

“Warren used to teach this lesson when he conducted a night class on investing at the University of Nebraska at Omaha…Warren would demonstrate that AT&T, before it broke up, was a poor investment for the shareholders, because though it made lots of money, it had to plow even more money than it made into capital expenditures…The way AT&T financed the expansion was to issue more shares and to sell lots of debt. But a company like Thomson Publishing, which owned a bunch of newspapers in one-newspaper towns, made lots of money for its shareholders. This was because once a newspaper had built its printing infrastructure it had little in the way of capital needs to suck away the shareholders’ money. This meant that there was lots of cash to spend on buying more newspapers to make its shareholders rich.”

So even though she doesn’t use the words free cash flow - she does use the word cash. And she makes a point of talking about cash that comes from sources other than issuing stock and taking on debt. Well - if you look at a Statement of Cash Flows - you’ll see that the free cash flow calculation includes only cash that doesn’t come from things like issuing stock and borrowing debt. Free cash flow is just cash from operations - that means cash created by the business - minus capital spending.

And that’s exactly what she’s talking about here. Mary Buffett clearly means free cash flow. But she doesn’t come out and say it in those words.

On page 110 Mary makes it even more obvious she’s really talking about free cash flow - not earnings per share. Here’s the question she asks:“Is the company free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases?”

Again - that’s clearly free cash flow she’s writing about. It can’t be anything else. You don’t use earnings to buy back stock. You use cash. And you don’t expand a business with earnings. That takes cash too. So even though she keeps talking about earnings - she’s really using earnings as a stand in for free cash flow.

Why does she do that? I don’t know. She may have thought she needed to keep the book simple and free cash flow was too complicated. Or maybe she wanted to use the same method to value all businesses - and as we saw with Progressive (PGR, Financial) - you can’t value an insurance company the way you value a soda company. You have to look at things like underwriting profit, investment income, and book value instead of focusing solely on free cash flow.

So the simple answer is that I don’t know why Mary Buffett kept saying earnings instead of free cash flow when she clearly meant free cash flow. And I can understand why this confused you. But I want to make sure you see that even though she never uses the words free cash flow - that’s clearly the number she’s talking about throughout the whole book.

I could give you other examples. On page 165 she talks about inflation. Free cash flow has a lot more to do with inflation than earnings. Because earnings use depreciation expenses based on historical costs instead of replacement costs. Free cash flow uses yearly capital spending - which means free cash flow gives you a better inflation adjusted picture than earnings per share.

And then on page 237 she writes about stock buybacks again. Mary writes about stock buybacks a lot in this book. And I think she’s right to do so. But I also think she’s wrong not to make it clear that the cash used to buy back stock comes from free cash flow - not from earnings.

And finally on page 287 she lists “Fifty-Four Companies to Look At”. A lot of those companies are gone now. But some of them are still publicly traded. And if you look each one up you’ll see they tend to have very high free cash flow compared to earnings. A lot higher than most businesses. So even though Mary doesn’t write about Warren using free cash flow - the companies she says he’s interested in are all big free cash flow producers. Some of them even have more free cash flow than earnings. Which is pretty rare. And definitely something she should have talked about.

Overall Mary Buffett did a bad job of explaining what she meant by earnings. She says Warren uses earnings - but then she gives tons of examples that obviously have to do with free cash flow instead of earnings.

Okay. Enough about Mary Buffett. Let’s talk about the man himself. In his 1986 Letter to Shareholders - Buffett used the words “owner earnings” to explain what he looked for in a business.

In the appendix dealing with Berkshire’s acquisition of Scott Fetzer - Buffett writes:

“If we think through these questions, we can gain some insights about what may be called ’owner earnings’. These represent reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges…less the average annual amount of capitalized expenditures for plant and equipment that the business requires to fully maintain its long-term competitive position and its unit volume.”

If you look at the formula he just gave there - it’s clearly free cash flow. The only difference is that Buffett says you want to separate capital spending meant to grow the business from capital spending meant to keep the business going as is. That’s a great point. And I agree with Buffett’s definition of owner earnings. Free cash flow understates owner earnings at growing businesses. At the same time - net income overstates owner earnings. The actual owner earnings number usually falls somewhere in between free cash flow and net income. It’s more than free cash flow but less than net income.

That’s not always true. But it’s true most of the time.

Buffett makes this point himself later in the same letter when he writes:

“…calculations of this sort usually do not provide such pleasant news. Most managers probably will acknowledge that they need to spend something more than (depreciation) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists - that is when (average capitalized expenditures) exceed (depreciation) - GAAP earnings overstate owner earnings. Frequently this overstatement is substantial.”

What Buffett’s saying here is that owner earnings are usually lower than reported earnings because depreciation is usually lower than what it costs to replace the thing you’re depreciating. In other words: you have to spend more than the original price of the thing you’re replacing to buy a new one. That’s true in most businesses - and that means accounting earnings usually overstate real world earnings.

For some businesses - like advertising agencies - that isn’t true. An ad agency does not have to spend than depreciation and amortization to keep the business growing. In fact - an advertising agency’s free cash flow is usually higher than it’s net income. And as long as the ad agency keeps growing year in and year out it should stay that way.

The difference between free cash flow and earnings only becomes a big issue when you compare two very different businesses. For example: when an advertising agency and a railroad both have the same price-to-earnings ratio - the advertising agency is actually selling for less than half the price of the railroad. That’s because something less than 50% of a railroad’s earnings turn into free cash flow - while more than 100% of an ad agency’s earnings turn into free cash flow.

So the only way an ad agency and a railroad can be equally expensive is when the ad agency’s P/E ratio is double the P/E ratio on the railroad.

I know that sounds crazy. But I’m telling you the truth. Go look at the financial records of any railroad and any ad agency you want. If you crunch the numbers the way Warren tells you to - you’ll see that an ad agency has to have a P/E ratio that’s double the railroad’s P/E ratio for the two stocks to trade at the same ratio of price to owner earnings.

Those are extreme examples. Almost no business throws off as little free cash flow compared to earnings as a railroad. And almost no business throws off as much free cash flow compared to earnings as an advertising agency.

Still - it’s a good idea to look out for situations like that - where accounting earnings hide the truth.

Warren said so himself in that same 1986 letter:

“Questioning GAAP figures may seem impious to some. After all, what are we paying the accountants for if it is not to deliver us the ’truth’ about our business. But the accountants’ job is to record, not to evaluate. The evaluation job falls to investors and managers.”

It’s your job to find the truth. And the truth is that Warren Buffett uses free cash flow - not pre-tax earnings - to value a business. He told you so himself in his 1986 letter to shareholders. And if you read Mary Buffett’s book closely - you’ll see that even she uses free cash flow. But for some reason she doesn’t say she’s using free cash flow.

I think she should have. It’s a bad idea to dumb things down for an audience that can handle the truth.

And the truth is that Warren Buffett uses free cash flow to value stocks.

Well that’s all for today’s show. If you have an investing question you want answered call 1-800-604-1929 and leave us a voicemail. That’s 1-800-604-1929.

Thanks for listening.

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