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?
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
- $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.
- $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.
- $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.
- $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.
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.