October 2019 – Why Reported Earnings can be Misleading for an Asset Heavy Business
“These (Owner’s Earnings) represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less (c) 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…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…All of this points up the absurdity of the ‘cash flow‘ numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) – but do not subtract (c)”
– Warren Buffett
One of the most important activities in investing is determining a company’s intrinsic value by making an educated estimate of the company’s Owner’s Earnings. But what are Owner’s Earnings? They are traditionally defined as the total of the net cash flows expected to occur over the life of the business, minus any reinvestment of earnings.
The standard way to calculate this number is by going to the cash flow statement and taking the cash generated from operations and deducting the outflow of cash that was spent on capital expenditures. In theory this is the proper way to do it, but every company is unique and presents their own challenges and ways that make it more complicated.
Take for example a company like CN Rail (TSE: CNR). This is a company that has a significant amount of tangible capital invested in its business (ex. rail network, terminals, rail cars etc.) which is continually depreciating over time. Every year a portion of CN’s capital needs to be upgraded (i.e. Maintenance Capital) and another portion of their capital program will be invested in projects related to growth opportunities (i.e. Growth Capital). A maintenance capital project for CN may be to replace the rail ties on a span of 100km of track in the middle of prairies. Capital invested in a growth project might be something like a new grain terminal in the prairies that will facilitate growth in future earnings by allowing additional volume to be shipped on the company’s rail network.
However, the cash flow statement is not necessarily going to tell you the division of this specific information. So, when you are calculating the owner’s earnings of a company like CN, you must make a guess as to what the division between growth capital and maintenance capital is by either looking at the notes of the filing or analyzing as much of the company’s financial history as possible.
Your goal should be to gain confidence of what a good estimate of the range of owner’s earnings are rather than trying to get to arrive at a precise number. This is done for a couple reasons, one you want to have a range because it provides some margin of safety to your calculations, and two, the number theoretically changes from year to year.
The owner’s earnings number can be drastically different than the reported earnings which can mislead a lot of investors into thinking a company is more profitable than is generally reported. A lot of CN’s current capital invested in its business was paid for many years ago when one dollar was able to purchase a lot more than it can today due to inflation. These capital/assets have been depreciated over time on a schedule that is based on “yesterday’s” prices even though when the time comes to replace the capital, CN will have to replace it in “todays” inflation adjusted prices.
Depreciation (based on historic numbers) is an expense on the income statement that is used to calculate earnings. It is not entirely reflective of the true cost of the business where comparatively the cash flow statement would be because it is showing the “present day” value of the cost to replace the aging capital. Therefore, CN’s owner’s earnings are consistently lower than its reported earnings.
There are however businesses that have higher cash flows than their reported earnings. This is generally caused by businesses that are asset light and driven by a business model that collects float (i.e. receives money before it can be recorded as revenue from customers or receives revenue before they must pay the associated expense). You see this in industries such as insurance, companies that accept prepayment for services or goods or retailers that can turnover their store inventory faster than their payment terms with their suppliers.
As Charlie Munger has said in the past “People calculate too much and think too little”. This statement applies to Owners’ Earnings. It’s never a straight forward calculation, you must think about what it is today, what it has been in the past and what it is likely to be in the future based on the fundamental economics of the business you are analyzing. Treat every business differently and come up with an estimated range that is based on your research and make sure you don’t pay too much for them.
If you have any suggestions, comments or feedback that you would like to share feel free to email me at alex@StockWriteUps.com.
Enjoy the Journey,