Owner Earnings

Imagine that you are the owner of a retail business. The earnings that you can take out of the business every year without affecting its competitive position is called as Owner Earnings. This is the excess cash that can be taken out without affecting the business.

Warren Buffett introduced this term in the 1986 letter to shareholders. In the 1986 Buffett purchased the company Scott Fetzer. If the company was not purchased by Buffett then its 1986 Net Income would have been \$40.23 million.  Buffett reported the Net Income for this company as \$28.60 million. What happened to \$11.63 million?

Balance Sheet

Looking at the Net Income of the two companies which is more valuable? Buffett writes

As you’ve probably guessed, Companies O and N are the same business – Scott Fetzer. In the “O” (for “old”) column we have shown what the company’s 1986 GAAP earnings would have been if we had not purchased it; in the “N” (for “new”) column we have shown Scott Fetzer’s GAAP earnings as actually reported by Berkshire.

Why should you care about the difference?

Imagine there is only 1 share in the company. If you are going to pay 10 times earnings then Net Income at \$40.23 million, you will end up paying \$402.3 million. At Net Income \$28.60 million you will pay \$286.0 million. The new company is valued 30% lesser than the old company.

Extracting the differences in Income Statement

Given below are the differences in items between the old and the new Income statement.

```Special non-cash inventory costs            -  4.98 million
Depreciation of plant and equipment         -  5.05 million
Amortization of Goodwill                    -  0.60 million
Non-Cash Inter-period Allocation Adjustment -  1.00 million

Total Difference                            - 11.63 million```

Extracting the differences in Balance Sheet

Buffett purchased the company for \$315 million. At that time Scott Fetzer carried \$172.4 million in its books. So the excess \$142.6  million (\$315 – \$172.4) million needs to be accounted for in the balance sheet. Given below are the differences in items between the old and the new balance sheet.

```Inventories                    - 37.3 million
Property, Plant, and Equipment - 68.0 million
Goodwill                       - 24.3 million
Deferred Tax Liabilities       - 13.0 million

Total Difference               - 142.6 million```

Buffett explains the Income Statement differences

1. \$4.98 million for non-cash inventory costs resulting, primarily, from reductions that Scott Fetzer made in its inventories during 1986; charges of this kind are apt to be small or non-existent in future years.
2. \$5.05 million for extra depreciation attributable to the write-up of fixed assets; a charge approximating this amount will probably be made annually for 12 more years.
3. \$0.6 million for amortization of Goodwill; this charge will be made annually for 39 more years in a slightly larger amount because our purchase was made on January 6 and, therefore, the 1986 figure applies to only 98% of the year.
4. \$1.0 million for deferred-tax acrobatics that are beyond my ability to explain briefly (or perhaps even non-briefly); a charge approximating this amount will probably be made annually for 12 more years.

Owner Earnings

Buffett defines owner earnings as

```Owner Earnings =
reported earnings plus (A) +
depreciation, depletion, amortization, and certain other non-cash charges (B) -
average annual amount of capitalized expenditures (C)

A + B - C```

Substituting the numbers

```                                     Company 0   Company N
Net Income (A)                          40.23       28.60
depreciation, depletion, ... (B)         8.30       19.93

A + B                                   48.53       48.53```

Since it is the same company the capital expenditure should be the same. Hence the owner earnings for both the old and the new company is the same. Buffett writes

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. The approach we have outlined produces “owner earnings” for Company O and Company N that are identical, which means valuations are also identical, just as common sense would tell you should be the case. This result is reached because the sum of (a) and (b) is the same in both columns O and N, and because c is necessarily the same in both cases.

Understanding what is behind the numbers is more important. Buffett writes

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.

13 thoughts on “Owner Earnings”

1. Very good analysis. They should hire to teach in business schools!

2. srinivas says:

Jana,

There are couple of questions I have on the differences between the old balance sheet and new balance sheet

1) the inventory value has increased from 77 m to 114.7 m for the same period how is it possible ? Post acquisition the value of goods has increased by 37m

2) the valuation in plant and equipment has increased from 80m to 148 m

These two you have listed in the differences to account for the excess money paid in relation to acquisition but overnight the value of these two cannot change ?

CAn you throw some light on this aspect of revaluation ?

Srinivas

• Jana Vembunarayanan says:

Srinivas,

The explanation for that is given by Buffett in his 1986 letter and I have pasted his explanation.
————————-
The contrast between O and N comes about because we paid an amount for Scott Fetzer that was different from its stated net worth. Under GAAP, such differences – such premiums or discounts – must be accounted for by “purchase-price adjustments.” In Scott Fetzer’s case, we paid \$315 million for net assets that were carried on its books at \$172.4 million. So we paid a premium of \$142.6 million.

The first step in accounting for any premium paid is to adjust the carrying value of current assets to current values. In practice, this requirement usually does not affect receivables, which are routinely carried at current value, but often affects inventories. Because of a \$22.9 million LIFO reserve and other accounting intricacies, Scott Fetzer’s inventory account was carried at a \$37.3 million discount from current value. So, making our first accounting move, we used \$37.3 million of our \$142.6 million premium to increase the carrying value of the inventory.
————————-

Regards,
Jana

3. Hi jana,

I am in love with this valuation method of owner’s earning. Now I can understand all of Prof Bakshi’s valuation related post. Thanks for explaining this. I want to explore this further apart from buffet’s 1986 letter, do you recommend any other resource ,any book or video.

Also your video of taking flight is awesome thanks for sharing. It fills me with energy.

Regards,

Sarvdeep Malhan

• Jana Vembunarayanan says:

Sarvdeep,

I like Accounting For Value and also try It’s Earnings That Count.

Regards,
Jana

Jana,

In the formula above for calculating Owners Earnings,, Firstly aren’t we missing change in working capital, which in some companies hugely impact the cash earnings you take home, secondly a part of advertising or R&D expenditure accrued that year would have created an intangible asset , as suggested by Bruce Greenwald in his book “Value Investing : From Graham to Buffet and Beyond”, Hewitt Heiserman JR. in his book “It’s Earnings that Count” and by Prof Bakshi in his lectures.

• Jana Vembunarayanan says:

Mallikarjun,

Your are correct. And I have covered it here https://goo.gl/UdC9d7

Regards,
jana

5. Mallikarjun says:

Thanks Jana, just started following your blog, it’s been a pleasure reading

6. Excellent post Jana, best explanation of this I’ve seen.

• Jana Vembunarayanan says:

Thanks David.

Regards,
Jana

7. YJ says:

Jana,

Great post. Thanks very much.

I don’t fully understand why the Owner Earnings formula adds back depreciation given that Buffett once said:

“In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. “. This was one of his arguments against the use of EBITDA.

The only way it makes sense to me is that the capex part of the Owner Earnings formula refers to maintenance capex which in turn is basically the equivalent of the depreciation of the existing fixed assets in the business.

Slightly confused so would appreciate any help on this

Best

YJ

• Jana Vembunarayanan says:

YJ,

Depreciation is a non-cash expense and it’s a subjective accounting entry derived by the management. There are certain rules to govern it. But the stated values might differ from the economic reality of the assets.

On other hand maintenance capex is a real cash expense and the management has to do it to keep the sales at the current level. Without it they will lose their competitive advantage. This is the reason why you deduct the former and add back the later.

In practice maintenance capex is hard to calculate. Here is one way to get an approximate value: https://goo.gl/UKwqnA

Regards,
Jana

• Srinivas Duvvuri says:

Jana,

I was reading thro your latest post on machine learning and traveling through the links to an older post . I got curios to read on evolution from graham to Buffett , the link took me to duke unviversity which doesn’t have the post any more . Does the link lead to the Bruce greenwald book or is it a post . I am curios to read about , if you don’t mind can you share the contents of the link .

Secondly you have been reading a lot on machine learning could you share the refererences that you have been using to learn .