How to correctly calculate owner earnings?

[Happy]

Buffett defined owner earnings as follows:

"These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges...less © the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ©.  However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)"

 

My question is what exactly he means with "certain other non-cash charges"?

For exampe, if I look at the 2013 AR of Microsoft, what should be my end result?

 

CASH FLOWS STATEMENTS

(In millions)

Year Ended June 30, 2013

Operations

Net income 21,863

Adjustments to reconcile net income to net cash from operations:

Goodwill impairment 0

Depreciation, amortization, and other 3,755

Stock-based compensation expense 2,406

Net recognized losses (gains) on investments and derivatives 80

Excess tax benefits from stock-based compensation (209 )

Deferred income taxes (19 )

Deferral of unearned revenue 44,253

Recognition of unearned revenue (41,921 )

Changes in operating assets and liabilities:

Accounts receivable (1,807 )

Inventories (802 )

Other current assets (129 )

Other long-term assets (478 )

Accounts payable 537

Other current liabilities 146

Other long-term liabilities 1,158

 

Net cash from operations 28,833

 

Investing

Additions to property and equipment (4,257 )

Acquisition of companies, net of cash acquired, and purchases of intangible and other assets (1,584 )

 

Does "certain other non-cash charges" include all of the operating cash flow items so that I arrive at "net cash from operations" or do I need to make adjustments / exclude items? If if were just Op. CF - Maintenance Capex, why didn't he write it simpler (I read somewhere that the accounting was different back then)?

 

My result would be $ 28,833 - $4,257 = $24,576. (I know you should take the average maintenance capex over multiple years, but let's leave that aside for now).

 

And if I wanted to calculate "Owner Earnings / Enterprise Value" instead of "Owner earnings / market cap", would I have to further adjust that number? As far as I know you can't use Net Income / EV as one is after debt/taxes and the other isn't, I guess that applies here as well.

 

Thanks

 

[Palantir]

You can use NI/EV, there is no rule that you must compare a before tax figure to EV. I don't use NI, so it is moot for me though.

[jschembs]

You can use NI/EV, there is no rule that you must compare a before tax figure to EV. I don't use NI, so it is moot for me though.

 

Why would you use NI/EV? Numerator is influenced by capital structure, denominator isn't.

[Palantir]

^ Because the debtholders have a claim on the income too - principal.

[VAL9000]

 

Does "certain other non-cash charges" include all of the operating cash flow items so that I arrive at "net cash from operations" or do I need to make adjustments / exclude items? If if were just Op. CF - Maintenance Capex, why didn't he write it simpler (I read somewhere that the accounting was different back then)?

 

 

I think the spirit of the definition is that you want to capture a reasonable picture of what the true ongoing expenses to the business are.  That's why you back out depreciation/amortization but include average CapEx.  CapEx is lumpy but a necessary cost to running a business.  If you just look at depreciation/amortization then you will get an unrealistic picture of cash outlay due to the rules associated with recognizing these items.

 

So "certain other non-cash charges" is asking - are these non-cash charges actually associated with real, on-going cash outlay, or are they not?  If they are not, then don't consider them as vital to running the business, and therefore they shouldn't impact owner earnings.  If they are, then include them as an on-going average cost.

 

Thinking of Microsoft, I would include all of the stupid acquisitions and eventual write-downs as an on-going cost.  Not because they necessarily need to keep spending billions every year to keep their moat, but because they do anyway.  So, that's the cost of "owning" Microsoft, and therefore impacts owner earnings.

 

 

 

[jwfm1985]

^ Because the debtholders have a claim on the income too - principal.

 

Still, not really a reason to use NI with EV - looking at that ratio at face value to compare 2 companies would be very misleading without digging into the capital structure IMO

[dpetrescu]

What about SBC expenses? Even though it is not a cash expense It doesn't really seem right to add back that amount.

 

Sure the cost will be reflected in the future per share amount. But technically Microsoft could pay all expenses with SBCs. If employees or vendors or the company's utility company won't accept msft stock for payment, Microsoft could sell MSFT call options on the open market, and use the proceeds to pay for all expenses including rent, paper, marketing, etc and this would allow all expenses to be net non-cash outlay. Depending on the future results, this might or might not be reflected in the per share amounts in the future. If it will be, earnings are guaranteed to be always positive as opposed to if expenses are recognized in which case negative earnings are possible. If it will not, MSFT paid expense out of thin air with magically high owner earnings.

[Happy]

What about SBC expenses? Even though it is not a cash expense It doesn't really seem right to add back that amount.

 

Sure the cost will be reflected in the future per share amount. But technically Microsoft could pay all expenses with SBCs. If employees or vendors or the company's utility company won't accept msft stock for payment, Microsoft could sell MSFT call options on the open market, and use the proceeds to pay for all expenses including rent, paper, marketing, etc and this would allow all expenses to be net non-cash outlay. Depending on the future results, this might or might not be reflected in the per share amounts in the future. If it will be, earnings are guaranteed to be always positive as opposed to if expenses are recognized in which case negative earnings are possible. If it will not, MSFT paid expense out of thin air with magically high owner earnings.

 

Good point. Sounds to me like it shouldn't be added to Net Income. Buffett and Munger repeatedly said that stock options are a real expense and that it is wishful thinking to treat them as anything else.

[VAL9000]

What about SBC expenses? Even though it is not a cash expense It doesn't really seem right to add back that amount.

 

Sure the cost will be reflected in the future per share amount. But technically Microsoft could pay all expenses with SBCs. If employees or vendors or the company's utility company won't accept msft stock for payment, Microsoft could sell MSFT call options on the open market, and use the proceeds to pay for all expenses including rent, paper, marketing, etc and this would allow all expenses to be net non-cash outlay. Depending on the future results, this might or might not be reflected in the per share amounts in the future. If it will be, earnings are guaranteed to be always positive as opposed to if expenses are recognized in which case negative earnings are possible. If it will not, MSFT paid expense out of thin air with magically high owner earnings.

 

Good point. Sounds to me like it shouldn't be added to Net Income. Buffett and Munger repeatedly said that stock options are a real expense and that it is wishful thinking to treat them as anything else.

 

For Microsoft, absolutely - their compensation model relies on stock-based compensation to attract talent.  This isn't the case for every company.  You need to apply the same litmus test to each business in isolation.  Significant stock-based compensation could be granted in connection with a one-time or infrequent event, such as an acquisition or new leadership.

 

It's still an expense, but the part that needs some careful consideration is whether or not it's an on-going expense, and to what degree is it on-going.

 

[LC]

I usually leave out changes to working capital. Working capital in most businesses changes over time...in reality working capital is a function of the business operations and usually we want those businesses to be consistently functioning (i.e. renewing working capital as the business uses it). You wouldn't want a grocery story to have shrinking average levels of inventories over time (i.e., not being able to move X amount of inventory so reducing average inventory on hand - a sign the business is decaying), so I usually don't add the "cash" provided by reduced inventories either. Same with the other working capital accounts.

 

My usual calculation:

 

NI + D&A + One-time (Extraordinary - only if they are truly extraordinary) charges - Capex

 

I don't really distinguish that much between growth and maint capex as much as other investors do. If I'm investing in a small, growing company, "growth" capex is part of that. To some companies, "normalized" environments include "growth capex". Sometimes (take Packer's example over in the Intralot thread) capex is a direct function of revenue. They win a contract, they pay capex as a result. So in that case it makes more sense to get an idea of "normalized" capex.