Investors and managers should use owner earnings, as defined by Warren Buffet in his 1986 letter to shareholders, to calculate earnings. This analysis applies to business valuation and management.
Owner earnings definition :
These 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. (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.)
– Berkshire Hathaway 1987 Annual Letter
https://www.berkshirehathaway.com/letters/1986.html
This definition came about as a result of Buffet’s need to explain the considerable economic differences between rules of thumb like EBITDA and pure accounting evaluations of earnings.
Why should investors use this definition vs the GAAP definition?
GAAP is far too precise to be used as a measure of future earnings. Future earnings necessarily involve some degree of reinvestment by a company. Buffet elaborates on this point by stating:
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. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.
Consider that GAAP requires a precise answer because tax considerations demand it. A range, which may be produced in a financiers view, will not be a sufficient answer for tax purposes or in uniformly reported financial statements required for public market participation. Investors need a way to compare apples to apples, GAAP allows that, but it has major flaws.
What are the implications for valuation and managers?
For many businesses, calculating owner earnings will force a re-evaluation of what was previously considered earnings.
- Managers and owners will likely need to spend something more than (b) on their business over the long term to hold ground in unit volume and against the competition.
- When the need to spend more to stay in place exists, and (c) > (b) then GAAP earnings overstate earnings.
What are the implications for investors?
For investors, the difference is not trivial. The GAAP definition and the owner earnings definition can produce wildly different valuation results and the real spend required to maintain a business’s competitive position in the market.
All of this points up the absurdity of the “cash flow” numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) – but do not subtract ( c) . Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business being offered is the commercial counterpart of the Pyramids – forever state-of-the-art, never needing to be replaced, improved or refurbished. Indeed, if all U.S. corporations were to be offered simultaneously for sale through our leading investment bankers – and if the sales brochures describing them were to be believed – governmental projections of national plant and equipment spending would have to be slashed by 90%.
“Cash Flow”, true, may serve as a shorthand of some utility in descriptions of certain real estate businesses or other enterprises that make huge initial outlays and only tiny outlays thereafter. A company whose only holding is a bridge or an extremely long-lived gas field would be an example. But “cash flow” is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, ( c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment – or the business decays.
The misuse of the definition of GAAP earnings as true economic earnings has found its way into the common diction of the main street investor. As a result, GAAP may enable bankers and consultants to present favorable numbers on behalf of their clients. The net effect is a separation of the accounting numbers from the underlying economic characteristics of the business.
Why, then, are “cash flow” numbers so popular today? In answer, we confess our cynicism: we believe these numbers are frequently used by marketers of businesses and securities in attempts to justify the unjustifiable (and thereby to sell what should be the unsalable). When (a) – that is, GAAP earnings – looks by itself inadequate to service debt of a junk bond or justify a foolish stock price, how convenient it becomes for salesmen to focus on (a) + (b). But you shouldn’t add (b) without subtracting ( c) : though dentists correctly claim that if you ignore your teeth they’ll go away, the same is not true for ( c) . The company or investor believing that the debt-servicing ability or the equity valuation of an enterprise can be measured by totaling (a) and (b) while ignoring ( c) is headed for certain trouble.
How does Buffet defend his position in contrast to what GAAP demands?
Our conviction about this point is the reason we show our amortization and other purchase-price adjustment items separately in the table on page 8 and is also our reason for viewing the earnings of the individual businesses as reported there as much more closely approximating owner earnings than the GAAP figures.
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.
Accounting numbers, of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress. Charlie and I would be lost without these numbers: they invariably are the starting point for us in evaluating our own businesses and those of others. Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it.
Takeaways
Owner earnings are the best real measure of distributable cashflows.
The cash flows from an owners earnings calculation represent the monies that could most accurately be taken out of the business over the course its future life.
GAAP accounting prescribes a particular definition and treatment of earnings, this necessary reporting standard exists for purposes outside of the investor and manager’s core role. The result is two definitions, often thought to be one and the same, that must be maintained.
The implications for the enterprising investor is clear. P/E ratios are a terrible evil hoisted upon markets. Thus, valuation pictures often presented by automatic screens are generally wrong.
The economic characteristics of a business must always be factored into every proper consideration of earnings. Future earnings require reinvestment, the cost of that reinvestment should be considered when projecting future cashflows. Managers and investors need only to determine the capital spend required to maintain present levels of profitability or growth to arrive at the true picture of future earnings.
