The earnings that you can take out of the business every year without affecting its competitive position is called as Owner Earnings. I wrote about it in detail here. This term was coined by Warren Buffet and the formula for calculating it is given below. The capital expenditure (capex) he refers to is maintenance capex and not growth capex. But how do we know the maintenance capex? If an investor knows the business very well then he might. But it is an elusive concept which requires too much judgment for most of the investors. For calculating the maintenance capex, I used to depend on the management. Most of the times they wont reveal it and the only choice I had was to use the deprecation reported in the income statement.
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
Wise men used to say that it’s not the book you start with, it’s the book that book leads you to. This statement came out to be true when I accidentally discovered Bruce Greenwald’s fantastic book. In it he explains how to calculate the maintenance capex.
Companies generally report capital expenditures in their statement of cash flows. We assume that each year, a part of this outlay supports the business at its sales level for the prior year, and part is needed for whatever increase in sales it has achieved. Companies generally have a stable relationship between the level of sales and the amount of plant, property, and equipment (PPE), net of depreciation, that they report. We calculate the ratio of PPE to sales for each of the five prior years and find the average. We use this to indicate the dollars of PPE it takes to support each dollar of sales. We then multiply this ratio by the growth (or decrease) in sales dollars the company has achieved in the current year. The result of that calculation is growth capex. We then subtract it from total capex to arrive at maintenance capex.
Let’s apply Greenwald’s method to calculate maintenance capex for the year 2014. Sales and PPE data for the company I made up is given below.
Step 1: The ratio of PPE-to-Sales shows how much needs to be invested in PPE for generating $1 of sales. In 2009 the company needed $20 in PPE for generating $100 in sales. This means it needs $0.20 in PPE for generating $1 in sales ($20.00 / 100.00). The average PPE-to-Sales from 2009 to 2013 comes to $0.24. Why average instead of last year’s ratio? Average normalizes peaks-and-troughs and our calculations will be less prone to distortions caused by business cycles.
Step 2: In 2014 the company increased its sales by $10 ($160 – 150) and its total capital expenditure increased by $8 ($50 – 42). In Step 1 we calculated that for generating $1 of sales the company on average needs $0.24 in PPE. For generating $10 of additional sales the company needs $2.40 ($10 * 0.24) in PPE which is the growth capex.
Step 3: Subtracting growth capex of $2.40 from total capex of $8 we get the maintainence capex of $5.60.
Bruce Greenwald is an amazing teacher and I would highly recommend you to read his book and watch his lectures