Lesson 34

Buffett's Owner's Earnings Calculation

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Lesson 34 Executive Summary


In this lesson, students learn the difference between accounting earnings and Warren Buffett's Owner's Earnings.


When an Investor looks at the bottom line figure on the Income Statement, they find the Net Income. This is the profit the company has produced for the given time frame. Although many people use the net income to value a business, Warren Buffett takes a different approach, and calculates what he calls the Owner's Earnings.


In order to understand the concept of Owner's Earnings, one must understand the two paths taken by the Net Income after it's produced. The first path is a potential dividend payment. Any funds that take this path are immediately valued as Owner's Earnings. The remaining amount of net income after the dividend payment is then used to invest back into the business. This money also has two paths. While one path is to use the money to reinvest into the maintenance and care of the already existing equipment, the other path is to spend the money on expanding the assets of the company. If the funds flow in the first direction, called Capital Expenditures, the company’s book value will display little or no growth at all. If the funds flow in the second direction, the money will add new streams of income to the business and the asset will be added to the current equity of the business. This second amount is added to the dividend and the total is referred to as the Owner's Earnings.


If an individual is interested in calculating the owner's Earnings, he/she could simply take the funds from the Operating Activities section on the Cash Flow Statement, and subtract it from the Capital Expenditures -- also found on the Cash Flow Statement.


Remember, the true Owner's Earnings is nothing more than the book value growth and the dividends combined.


In order to read Warren Buffett’s exact notes on Owner’s Earnings, be sure to follow this link to his 1986 Shareholder’s Letter. The portion on Owner’s Earnings can be found at the bottom of this document.


The most important thing to take away from owner’s earnings is to understand the concept more than remembering simple formulas. As a shareholder you want to know the amount of value the company is making, and how much of that is flowing back to you. This is, in essence, what owner’s earnings are all about. Accounting both intentionally an unintentionally misleads the investor, but at the end of the day, the real value that is being created for the shareholder is all that counts.


At the end of the lesson four main pointers are provided:


  • 1) Fully understand the difference between owner’s earnings and accounting earnings
  • 2) Continue to value companies based off the book value growth and dividend
  • 3) When assessing the future earnings of the business, ensure that the estimate remains stable or is increasing
  • 4) Check the Cash flow statement quarterly, to ensure that the ratio between the operating activities and Capital Expenditures remains intact.

  • Owner’s earnings are just one example of how Warren Buffett has reinvented investment and seen new opportunities where he is one step ahead of the pack. Tap Dancing to Work by Carol Loomis gives you a unique insight of Warren Buffett’s more advanced thoughts and actions on investment. I've read this book and enjoyed it very much. Carol does an outstanding job capturing important Buffett topics.

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    New Vocabulary


    Accounting Earnings

    The accounting earnings are often referred to as “reported earnings” and it is located at the bottom of the income statement as “net income”.


    Owner's Earnings

    The owner’s earnings are referred to as “Free Cash Flow”. The accounting earnings that is in reality turned into earnings for the shareholder. It is calculated as: Cash from Operating Activities – Capital Expenditures.


    Capital Expenditures

    The capital expenditures are the expenses the company incurs when replacing assets. Examples of assets that need replacement are typically cars, plants, and other operating equipment.

    Owners Earnings - Lesson Transcript


    From the beginning, the income statement is used to figure out the EPS or the net income of the business. It’s the profit of the company. To figure out the profit per share, take the net income divided by the number of shares outstanding. From the previous lessons, EPS is paid to the shareholder in two different ways. First is directly through a dividend.


    Here’s a very generic scenario using the $2. The business has a book value of $20. The previous book value prior to 2009 was $20. The $2 earnings per share are divided. $1 is paid to the owner as a dividend and the other $1 was reinvested back into the company. It made the book value grow by $1. The book value changed from $20 to $21 in 2009. The same, exact scene occurs in 2010 as the book value rose to $22. $1 of a dividend was paid. In 2011, the exact thing occurred, thus raising the book value to $23.


    In that scene, what were the earnings per share and the owner’s earnings? Accounting is actually about earnings per share. The owner’s earnings are also $2, because $1 is earned from the dividend. The other $1 being reinvested in the company actually materializes the book value. The actual accounting earnings that were being reported are exactly the same as the owner’s earnings.


    The next scenario is more realistic. The money being reinvested back into the company might not actually turn into owner’s earnings. We have the same exact company.


    Year 2009 Year 2010 Year 2011
    EPS: $2.0 EPS: $2.0 EPS: $2.0
    Dividend: $1.0 Dividend: $1.0 Dividend: $1.0
    Book Growth: $0.5 Book Growth: $0.5 Book Growth: $0.5
    Book Value: $20.50 Book Value: $21.00 Book Value: $21.50

    Instead of seeing the book value in 2011 at $23, it’s just $21.50. The depravity is the difference between reported earnings coming from the accounting and the owner’s earnings, which are slightly different. The accounting earnings are $2 and the owner’s earnings are only $1.5 per year. Where did the $.50 of earnings go? That never materialized! It’s your money, but where is it?


    Again, there are two directions that the EPS can go. When it’s paid as dividend, it materializes as the owner’s earnings immediately. The other dollar invested down the business may or may not turn to owner’s earnings. This will be discussed in the following paragraphs.


    The EPS is $2, and $1 is invested back into the business. It’s a whole lot more than this, but to make sense, we’ll just make two paths. On one path, $.50 was used to invest in another stock. If a company has the ability to take its earnings and invest that money in another company, it’ll continue to pay them earnings. It’ll show in their balance sheet as another asset. That would materialize as an extra book value. The other $.50 is invested back in the company by replacing computers that they already possess. That old computer on the balance sheet listed an asset was replaced with a new computer bought with the $.5 of the share. The new computers replace the old computers on the balance. That didn’t add any more money on the balance sheet and the book value, but as far as we are concerned, it almost seems like that money disappeared!


    Now that you understand the basic concept of owner’s earnings, go ahead and try to do it for Walmart, which is a real business.


    Warren Buffett’s quote on owner’s earnings is, “Owner’s earnings are reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges (to include or exclude deferral taxes)”… and less the average annual amount of capitalized expenditures for plant, equipment, etc. that the business requires to full maintain its long-term competitive position and its unit volume.”


    The cash flow statement for Walmart is shown in the video. Remember, just go to MSN Money and type the ticker for Walmart, and click cash flow. To make sense of what Buffett’s quote means, I’ve broken it down:


    Owner’s earnings =


    +net income


    +depreciation


    +amortization


    +non-cash items


    +/-deferred taxes


    -capital expenditures


    Buffet wrote that piece when there was only an income statement and a balance sheet; therefore, he didn’t have the luxury of viewing ac cash flow statement. It’s easier now. In the video, the terms are highlighted so you could spot them.


    Capital expenditures are the expenses used to sustain the operations. If you were to purchase stocks, that’s not going to be listed. Only those that are currently used to produce current income strains are listed. Therefore, we will subtract all those elements out. Take the difference between the two to come up with the real owner’s earnings as opposed to the EPS being reported.


    Compare Walmart’s accounting earnings and owner’s earnings. First, calculate the number at the bottom of the income statement from the cash flow statement. Look at the very top number, the net income, and then the number of shares diluted listed underneath the income statement. The EPS diluted, just take the net income divided by the numbers of shares outstanding. Diluted numbers give accurate numbers.


    Now, we will work on the accounting earnings. For 2007, Walmart had $4.71 all the way to 2008 where it was down at $3.23.


    To get the owner’s earnings: To do this, go the cash flow statement. Take the operating activities and the capital expenditures to find the difference. You’ll come up with $10745 for 2012 all the way to 2008 where it’s $5705. Those numbers are in billions, because we dropped all the zeros. The difference is the owner’s earnings.


    To figure out per share, divide the difference by the number of shares diluted. At the bottom are the owners earnings diluted - $3.09 in 2012 and $1.40 in 2008. Look at the EPS’s accounting number and owner’s earnings.


    The chart in the video is for easy use. The blue is the owner’s earnings. The red is the accounting earnings. You’ll see how much higher the accounting earnings are displaying versus what’s being materialized for the owners. If you were the shareholder, you’d see the numbers in blue coming in your pocket, as opposed to what is being reported in the accounting income statement. That’s a pretty significant difference! That’s why Buffett puts so much value in this.


    Make it fun. On the top of the video are the accounting earnings and the owner’s earnings are located below that. Observe the chart and study the differences.


    Walmart Earnings
    Year 2012 2011 2010 2009 2008 Total
    Accounting EPS $4.71 $4.63 $3.83 $3.51 $3.23 $19.93
    Owner's Earnings $3.09 $2.98 $3.62 $2.95 $1.40 $14.05
    Dividend $1.46 $1.21 $1.09 $0.95 $0.88
    Book Value $1.37 $0.88 $1.98 $0.37 $1.35
    Actual Earnings $2.83 $2.09 $3.07 $1.32 $2.23 $11.54

    Another reason why Buffett likes to minimize his net tangible assets is because net tangible assets will most likely need to be replaced or maintained. This means a decreased amount of Owner’s earnings. Examples are the computers, the buildings, the facilities, etc.


    What’s the point? How can you use this to your advantage?


    A lot of people read Buffett’s description on owner’s earnings like it’s the holy ground of value investing. It’s very important to understand his calculation, but understanding the concept of owner’s earnings is more important. Remember, the actual owners earnings are a combination of two things – book value growth + dividends.


    The context of Buffett’s 1986 stockholder’s reports is:


  • 100% buyout of Scott Fetzer’s
  • Almost 100% premium over the net tangible assets
  • Had to prove his valuation with accounting terms and CAP rates

  • These are all the reasons for his detailed explanation and accounting gymnastics that was seen on the Berkshire Balance Sheet that year.


    Meanwhile, my recommendations are:


    Understanding the calculation is great. You have fully underrated the difference between owner’s earnings and account earnings from a general standpoint. What I was talking about in the beginning is what you had to understand. All that EPS isn’t going to materialize into actual earnings into your pockets.


    Continue valuing your company based off the book value growth and the dividend because, ultimately at the end of the day, if that company invests all the money being put back into the company, you’re not going to see the book value growth. You’ll see that trend especially when you’re buying a stable company, which is mandatory for all of us. When a good company’s book value is not trending, it means only your dividend will turn into owner’s earnings.


    When assessing future earnings of a business, ensure your estimate is stable or increasing.


    Check the cash flow statement quarterly, to ensure the ratio of operating activities and captain expenditures are intact.


    Let’s go ahead and do the third recommendation and then the fourth.


    Go to MSN Money and look for Walmart’s future earnings. To get a brief idea of what their past earnings are, check the last 10 years. Walmart’s earnings per share over the last 10 years went from $1.78 up until $4.54 in 2012. The growth is trending.


    Let’s see their earnings in the future. Click “earnings” on the left said of screen. For 2013, their earnings are $4.90. The projection for 2014 is $5.36. There are 22 analysts in 2013 and 20 analysts in 2014 predicting this. However, what are the chances of those earnings coming into reality? There’s no assurance, BUT this is better than seeing a negative projection.


    Our last recommendation is that you take a go look at the cash flow statement since you’ve seen the projection increasing in the future. Pull up interim for each quarter. Assess the cash from operating activities compared to the capital expenditures. The long term trend is what we’re looking for. We make sure it’s not decreasing. It should either be stable or increasing.