Understanding Buffett’s Owner Earnings for Beginners

As we continue to get more and more into the weeds with Warren Buffett in his book, ‘The Essays of Warren Buffett’, he focuses on Owner Earnings in this chapter and just how skewed that they can become if you’re not evaluating them properly. 

Buffett begins the chapter by showing a balance sheet of two different companies and asks the reader to identify which company is worth more.  The balance sheets look very similar to one another except the Net Income of the first company is just over $40 million while the second company is just under $29 million.  I mean, obviously the company with the $40 million in earnings is worth more than the other, right?

Well, turns out that the two companies are actually the same exact company – Scott Fetzer.  The only difference is that the company with $40 million in earnings would be if Berkshire didn’t purchase Scott Fetzer and the company with $29 million in earnings is the actually reported earnings by Berkshire.

So, why the heck are the earnings so drastically different when literally nothing about the business has changed?

Essentially, it all boils down to the fact that Berkshire paid a premium (which is very common when buying a business) of $142.6 million to purchase Scott Fetzer.

All sudden done, Scott Fetzer was now worth $142.6 million less, on paper, after being purchase by Berkshire than it was when it was still a standalone company.  Make sense?  No?  Didn’t think so.

The company is worth no more or less than it was before being purchased, right?  So why has the ‘value’ changed so much?  Buffett urges us to think about Owner Earnings, which is essentially taking Reported Earnings + depreciation, depletion amortization and other non-cash charges – average annual amount of capex for plant and equipment that the business needs to continuously update and maintain.

Using this approach that Buffett has outlined will in turn product a valuation that is identical for both companies which is really the actual reality of the company instead of what is being reported.  Essentially, it’s taking out a lot of the fluff that is being included in the value of the company since Berkshire paid a premium to acquire them. 

I’m purposefully avoiding saying ‘overpaid’ because paying a premium is something that is expected when purchasing a company, so it’s much more of a norm than not.

Buffett later goes on a ‘rant’ about how ridiculous it is that such a large importance is placed upon people talking about cash flows in the investing world because it’s quite simply taking the reported Net Income and depreciation and amortization and other non-cash charges, but it’s not taking into account any ongoing charges that are necessary to maintain that company’s competitive position (capital expenditures). 

In essence, it’s only taking in part of the equation and totally eliminating the bad.

Buffett’s owner earnings formula, instead, is the following:

Owner’s earnings = Net Income + depreciation, depletion, and amortization and other non-cash charges – “maintenance” capital expenditures.

I mean – think about it.  I think that’s a pretty important aspect if it’s a consistent, ongoing cost to simply maintain your current position, is it not?

He uses oil companies as an example here because the oil industry has such a large importance on maintaining your infrastructure as that truly is what is your business is primarily focused upon. 

There are such large amounts of money being dedicated into running your exploration equipment, refineries and terminals as an oil company that it’s illogical to simply ignore those costs when you know that they’re repeatable, ongoing expenses, and that if you choose to not invest that money back into your machinery then you’re going to rapidly lose ground on your competitive position in the industry.

Now, of course, not all businesses are like that, but that’s why it’s so imperative to include that type of information when you’re looking at cash flows because if you don’t, you’re really comparing apples to apples if you’re comparing a company with heavy annual capital expenditures vs. one that doesn’t require nearly that type of investment.

As you can tell from this chapter, Buffett is not a fan of how many companies are reporting their cash flows.  To be honest, I don’t think that I can disagree with him either.

To completely eliminate such an important aspect like capex is really taking a narrow-minded approach to how the business is actually performing. 

At the end of the chapter, Buffett ties it all back to his example when Berkshire purchased Scott Fetzer.  At the end of the day, that value of that company hasn’t changed at all, so why would the reported numbers change?  It’s all simply just because that’s how they’re required to report it even though it’s giving an unfair, ultra conservative view of how the company is.

Berkshire makes it a point to show their amortization and other purchase-price adjustments separately, as well as breaking earnings from each company out individually, so that they can avoid this type of confusion, but not everyone will do this.

My main takeaway when reading this chapter is something that I’ve always preached to you all, and that’s just the importance of doing your own research and analysis.  It would be very easily to look at Scott Fetzer either before or after the company was purchased and then wonder what had changed when Berkshire bought them and wonder if Berkshire was killing the value of the company.

If you just take things at face value, then you’re never going to truly understand some of the intricacies of the investing world, and it could really set you up for failure. 

I’m not going to lie, Owner Earnings is a pretty in depth subject and can definitely be confusing, but the fact of the matter is that if you’re not reading into the company’s 10-k or doing research on your own, you’re going to be making a decision to buy or sell a stock off of information that is just flat out incorrect.

So, if you’re going to take away one piece of information from this post it’s this – make sure that you understand the whole picture before making any type of investing decision.  Oh, and maybe go buy ‘The Essays of Warren Buffett’ – it’s definitely not all as in the weeds as this chapter but every single thing that I have read has been truly invaluable information.

Learn the art of investing in 30 minutes

Join over 45k+ readers and instantly download the free ebook: 7 Steps to Understanding the Stock Market.

WordPress management provided by OptSus.com