How Much is a Company Really Making for its Owners?
Often enough, you hear people discuss stock market prices. You hear them speculating whether it will go up or down, and even why. You are bombarded by news, with percentage points a company gained or lost. For God’s sake, even on a MacBook, you get the stock tickers moving from red to green, and back to red pretty much every minute!
And there you see it.
AEX gained +1% today.
NASDAQ closed at -0.3%.
Amazon sells now at $2,000!
Wow. Let’s pause for a second.
Say that Amazon is indeed selling at $2,000. So what?
Would you buy it? Is that too high? Too low? Is that a fair price? How do you know?
That’s the question we’re gonna try to answer with this series of articles on the Owner Earnings Formula (Part 1, Part 2 and Real Life Assessment), in this blog article. How do you know what’s a fair price for a company based on what they’re actually making? It can be any company, in principle, but I’ll focus on established public companies because of all the public information available on them.
There are many answers to this question. But let me start by a classic from Berkshire Hathaway’s investment philosophy: the owner earnings formula.
Little side note here, for those of you who might not know. Berkshire Hathaway is Warren Buffet and Charlie Munger’s investment company. Arguably the most successful investment company in this world. Buffet has, every year since 1977, shared bits and pieces of his investment philosophy in his letters to shareholders. The capitalization pricing method is a part of his overarching investment philosophy.
The Owner Earnings Formula From Berkshire’s 1986 Letter to Shareholders
In 1986 Berkshire bought an Ohio-based branding and manufacturing (private) firm called Scott Fetzer Company. According to Berkshire’s analyses, Scott Fetzer’s was a once in a lifetime deal perhaps except for the total acquisition size, which they would have like to be higher for tax purposes. But that’s another discussion, maybe for another article.
In the 1986 letter, Buffet presents the Scott Fetzer’s finances, the GAAP and non-GAAP accounting reports and the estimation of the acquisition price based on what Buffet calls owner earnings. This is to justify the acquisition to the shareholders and try to answer the question: “how much money did the acquisition make for us?”. Before we get to that question, let’s clarify an odd abbreviation that just popped up in the paragraph before. GAAP.
Generally Accepted Accounting Principles
GAAP is short for Generally Accepted Accounting Principles. These principles are adopted by the Security and Exchange Commission (SEC) to paint a “clear” picture of a company’s financial performance to its investors. I said “clear”, because accounting is more of an art form, with its acrobatics and tricks, and as a result understanding financial performance can be a lot more difficult than you might think. Let’s leave them aside for a second and go back to our branding and manufacturing company: Scott Fetzer’s. You’ll see GAAP earnings and other financial metrics on your way to calculating the owner earnings.
Net Income and Accounting Tricks
One more time, the question here is – how much money did the acquisition make for the shareholders? Or in other words – how much money did the company make?
But, wait a second. Isn’t net income the answer to the question? Well, that’s GAAP. But the thing is, there’s many ways to get to that number with smart accounting tricks.
Look at the numbers below, reported in the 1986 letter to shareholders.
($ in thousands) | Company A | Company B |
Revenues | $ 677,240 | $ 677,240 |
Costs of Goods Sold | $ 349,471 | $ 359,504 |
· Historical costs | $ 341,170 | $ 341,170 |
· Special non-cash inventory | – | $ 4,979 |
· Depreciation | $ 8,301 | $ 13,355 |
Gross Profits | $ 327,769 | 317,736 |
Selling and Admin Expenses | $ 260,286 | $ 260,286 |
Amortization of Goodwill | – | $ 595 |
Operating Profits | $ 67,483 | $ 56,855 |
Other Income, Net | $ 4,135 | $ 4,135 |
Pre-Tax Income | $ 71,618 | $ 60,990 |
Deferred taxes | $ 31,387 | $ 32,385 |
Non-cash Allocation Adj. | – | $ 998 |
Net Income | $ 40,231 | $ 28,605 |
Do you want to know the weird thing? Company A and B are the same company: Scott Fetzer’s?! Just different accounting principles used, both GAAP. So, once again, how much money is the company actually making? Is it making $ 40 million dollars or $ 28? That’s a big difference!
Owner Earnings Formula
This is where owner earnings come in pretty darn handy to clarify this financial mess. Owner earnings are, quoting from the 1986 letter to shareholders:
- the reported earnings (aka net income) +
- depreciation, depletion, amortization and certain other non-cash charges –
- the average annual amount of capitalized expenditures for plan and equipment etc. that the business requires to fully maintain its competitive position and unit volume.
Woah. OK. That was a mouthful, I know. Let’s break it down and translate it to English…
Reported Earnings
Easy, right? We know that. It’s the net income of company A and B. Fine. Next.
Depreciation, Depletion, Amortization …
This requires some explanation.
Every company owns assets and liabilities. By definition, these are things that either put money in the company’s pocket (assets) or not (liabilities). The net change is taken into account in the owner earnings!
So, taking a look at the Scott Fetzer’s financial results, we see this:
Company A | Company B | |
Depreciation | $ 8,301 | $ 13,335 |
Amortization | – | $ 595 |
Other non-cash charges | – | $ 5977 |
The average amount of capital expenditures for maintenance
This is the most difficult one. First of all, capital expenditures (or also called Purchase of Property and Equipment) are funds used by a company to grow and maintain its operations. Here we need to estimate what part of that is used to maintain the operations. The crazy thing is, that the maintenance capital expenditure is NOT GAAP?!
So how do you guess that?
Here’s a little trick I use.
Question # 1 – Do I understand the business well enough to either estimate it myself?
Question # 2 – Do I find enough explanatory notes in the annual report explaining how the company used the total capital?
If the answer to both questions is NO, then I take the whole Purchase of Property and Equipment value. Just to be conservative!
For Scott Fetzer’s Berkshire estimates the maintenance capital expenditures at around $ 10 millions (or quoting “very close to $ 8.3 M, and much lower than $ 19.9 M).
Final Price – Scott Fetzer’s Owner Earnings in 1986
So, putting everything together, how much did Scott Fetzer’s make in 1986? What were their owner earnings?
Company A | Company B | |
Reported Income, Net | $ 40,231 | $ 28,605 |
Depreciation | $ 8,301 | $ 13,335 |
Amortization | – | $ 595 |
Other non-cash charges | – | $ 5977 |
Maintenance CapEx | $ (10,000) | $ (10,000) |
Owner Earnings | $ 38,532 | $ 38,532 |
Well, look at that! All of a sudden Company A and Company B are making the SAME amount of money for shareholders. What a surprise – since they’re the SAME company!!!
Despite the fact that the last piece of the puzzle, namely the maintenance capital expenditures, are a tough number to estimate, the owner earnings are a much better way to represent the real company earnings, or in other words the real value of the company.
The motto here is, I’d much rather be vaguely right than precisely wrong. So forget the GAAP metrics and focus on what matters – owner earnings.
That’s all for Part 1. Let is sink in and get started tomorrow with Part 2 where we look at owner earnings for public companies and the estimation of a fair price!
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Disclosure
These are unqualified opinions, and this newsletter, is meant for informational purposes only. It is not meant to serve as investment advice. Please consult with your investment, tax, or legal advisor, and do your own research.
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