How Much is a Company Really Making for its Owners?
In Part 1 of Owner Earnings, we started scratching the surface of estimating a company’s real earnings. Not what they say they earn, under the GAAP net earnings, but the real earnings for the owners. Again, the question we are trying the answer is:
Imagine you owned this company, the whole company, how much money would you be making at the end of the year?
In the example we looked at in Part 1/2, Berkshire acquires the whole company (called Scott Fetzer’s) offering a price that was based on the owner earnings they estimated, independently from the reported earnings. The same approach can be used to estimate a (max) price that is fair to pay for a company on the stock market. Even if you’re just buying 1 single share. It doesn’t matter. The approach remains the same – you wanna know first how much money the company is making and based on that you estimate what a fair price should be.
Never forget – buying a share = buying a company. You’re voting with your money, supporting a business.
In my opinion, there’s a few requirements a business has to meet before deserving my support. I’ll share mine in a separate article. For now, let’s look at its earnings only. Which is itself a pretty darn important requirement!
So, where do I start? From a little (not-at-all-little-and-boring-as-hell) collection of documents called Annual Reports.
Where to Find All You Need From Annual Reports
Annual Reports. Let’s have it.
This is the place where you (are supposed to) find all relevant financial and managerial information about the company you’re interested in. Annual reports are published by every public company as a duty towards their shareholders, who want to be brought up to speed with the latest developments and financial performance. The reports are usually published between 3 to 6 months after the end of a fiscal year (December 31). In other words, they give an overarching picture of what the company when through in a year time, and you as an investor get to take a look in the recent past at financial performance of the company you put your money in!
At the start of the paragraph, I’m saying that you are supposed to find all relevant financial information about a company because… it ain’t that easy. At first. With time, I found my ways around the accounting jargon, endless accounting acrobatics etc etc.
Let me make it easier for you. Here’s two (so called) statements you wanna find in the annual report, rip out (or print, that works too) and keep in front of you while you are trying to figure out prices.
- Income Statement
- Cashflow Statement
Income Statement
This is probably the easiest and most deceitful one. The income statement is the official profit and loss statement of a company. It tells you how much the company made from the sales of their products and services, how much it made from extra activities (called gains) and how much it spent or loss overall.
Quite clear, isn’t it? Well, no. The income statement can be misleading because of a number of Generally Accepted Accounting Principles (GAAP) that are used to paint a picture of a company’s earnings. Let me give you an example, a simple one.
This is How Misleading Income Statements Can Be
Imagine you are a 1-man company, investing in the market and selling stocks. In 2019, you made € 100,000 (one thousand euros) from commissions on the stocks you sold. I’m talking cold hard cash in your pockets from selling stocks. At the start of 2019 you also owned € 100,000 worth of shares in the stock market. By the end of 2019, that money accrued (fancy term to say growed) to € 150,000. This is not cash in your pocket, just the value of your account by December 2019 grew by € 50,000 to € 150,000.
According to GAAP, when you publish your annual report for your 1-man company, you will have to report the €50,000 as net earnings?! What?! Yes. Even if it’s not in your pocket.
It gets even weirder when you imagine what happens if the economy crashed and the worth of your account is suddenly € 0, in which case you “lost” € 100,000. Officially, your 1-man company would have € 0 earnings. While there’s € 100,000 in sales commission in your pockets.
OK, I know. This is waaay oversimplified and extreme. It just goes to show how misleading the GAAP earnings can be when it comes to understanding the financial situation of a company.
But let’s go back to the income statement. What do we take from this? What’s important here?
What You Need From the Income Statement
From the income statement, you want to highlight and write down these three pieces of info:
- Weighted average of common shares (or also called basic shares)
- Net income
- Income tax
Equivalently, instead of net income + income tax you can also note down directly the pre-tax income.
Little side note here, if your reaction to weighted average of common shares was – WTH did you just say? It’s okay. For now, I’ll tell you what you need to know – this is the number of shares available to purchase on the stock market. Why the fancy name? We’ll talk more about this in a later article!
All clear so far? Let me recap, before we move on.
- Download an annual report.
- Search for Income Statement (or Consolidated Income Statement)
- Note down pre-tax income (net incomes/earnings + income tax)
- Note down the weighted average of common shares
That’s it. Next statement – Cashflow.
Cashflow Statement
This is probably the most important statement you need to look at in an annual report. Here you see exactly how much cash has come in and out of the company. In general, using $20 words, what puts cash in your pocket is something called assets. What takes it out of your pocket is a liability. Period. You can find countless more poetic description selling at $2,000 per syllable, but the core of it is just this simple.
Asset = Anything that puts money in your pocket
Liability = Anything that takes money out of your pocket
There’s plenty of things to say about these two guys. But let’s keep it to this for now. And know that the movements of cash are captured in the cashflow statement. Without further a due, let’s get to what’s important from this statement. Here the list is a little longer. Bear with me, I’ll break it down for you.
This is what you want to remember from this statement:
- Depreciation and Amortization
- Account Receivables (Net)
- Account Payables (Net)
- Purchase of Property and Equipment (sometimes called Total Capital Expenditures)
- Other Purchases (sometimes called Maintenance Capital Expenditures)
Let’s look at them one by one and understand what these numbers are telling us.
Depreciation and Amortization
When explaining the cashflow statement, I mentioned that it captures the cash movements coming from, amongst other things, the company’s assets. Assets are resources owned by the company. Apart from generating cash for the company, these resources can lose, maintain or increase in value over the course of a year. The net difference is what we’re interested in and this value if found in the cashflow statement.
Examples of assets are properties (i.e., real estate owned by the company), technology components, proprietary resources etc.
Account Receivables (Net)
Account receivables is accounting jargon for money you still need to receive from your customer for services you have already provided or products you have already sold.
Example, a company selling pasta sells a total of 2,000 kg to a big restaurant. They send the invoice for €20,000 and request payment within 90 days. Imagine the fiscal year ended before that, or for some reason the restaurant delayed the payment, €20,000 will be carried in the annual report of the pasta company as account receivables in 2020.
However, what we’re interested in is the net difference between 2019 and 2020. Imagine this scenario, the pasta company carries €10,000 in account receivables from 2019, and €20,000 from 2020. In this case, it effectively lost €10,000. This net difference is what you’ll find in the cashflow statement and what you should pay attention to.
Account Payables (Net)
Payables are money the company owes to its suppliers. Back to the pasta company. To produce the 2,000 kg of pasta for their client (the big restaurant chain), they bought in €5,000 worth of flour from their supplier. Since they give their clients 90 days to pay for the pasta, they ask their suppliers 180 days to pay the invoices. The fiscal year has ended, the restaurant has delayed their payment, and you also didn’t pay the flour supplier.
In your annual report, next to the €20,000 carried as account receivables (in $20 words – the restaurant still hasn’t paid), you carry €5,000 in account payables (as in, I still haven’t paid for the flour).
Once again, we are interested here in the net difference between 2019 and 2020. Imagine in 2019 you carried €1,000 in payables. As you know, in 2020 it became €5,000. So, in terms of cash flow you gained €4,000. This money is still sitting in your accounts, since you haven’t paid it our yet.
Purchase of Property and Equipment
Purchase of property and equipment, also called total capital expenditures, tells you how much money the company has invested to grow and maintain its operations. If you’re a company making pasta, your capital expenditures will most likely be new machineries to produce pasta and increase your volume, new facilities perhaps in new countries, maintenance of existing factories etc.
This is an important number, where a lot of accounting tricks can be applied to. From the total capital expenditures, you are interested in the part related to maintenance. Why? Without taking into account money you invest to finance your growth, you want to know how much money the company spends annually to sustain its operations and maintain its volume. This amount is called maintenance capital expenditures, quoting a great investor and mentor of mine: Phil Town (author of Rule #1 Investing).
So, how do you get this number?
A Cheatsheet to Calculate Maintenance Capital Expenditures
I have to say this is a tough one. Here’s how I approach it.
Step 1 – Sometimes companies break down the total capital expenditures in the cashflow statement. In this case, you can pick and choose the components you want to include in the maintenance capex. Oh yeah, capex is the cool way of saying capital expenditures.
Step 2 – I look for explanatory notes in the annual report related to the total capital expenditures. Sometimes, if the total capex is not broken down in the cashflow statement, you find a lot of useful information in fine print and explanatory notes that allow you to estimated maintenance capex.
Step 3 – If Step 1 and Step 2 don’t tell me anything useful, I take the full total capex as my maintenance expenditures. This is my last resort. By doing so, I am estimating a more conservative price for the company which means I’m NOT losing money.
After all, quoting Buffet here, that Rule #1 in investing – DO NOT LOSE MONEY.
Owner Earnings Formula
I promised you all this talk about annual reports will help you estimate the owner earnings, the famous metric to estimate what a company is making for its owners mentioned in Berkshire’s1986 letter to shareholders.
Good news is, with all information collected from the annual report, you can now estimate the owner earnings, and a “fair” price you’d be willing to pay for the company. How? Like so.
Owner Earnings | = |
Pre-tax income | + |
Depreciation and amortization | + |
Account payables (net) | + |
Account receivables (net) | + |
Maintenance capex |
Note that some of these quantities may be negative!
Let’s take some rest now! We’ve covered a lot in this article despite the fact that there’s one missing piece in this whole story – what is the price of the company? How much money should I pay for this company?
I will answer that question in a different article, fully dedicated to using owner earnings to calculate price! So, you’ll finally know what to do with a number I asked you to note down but haven’t used yet – the weighted average of common shares.
Stay tuned! And celebrate because understanding annual report is an important part of your journey to a successful investment!
Newsletter
Stay up-to-date with the latest developments in the stock and crypto market., fund, and crypto market.
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.
No comment yet, add your voice below!