Tuesday, March 27, 2012

Contemplation on Owner Earnings: Buffett's 1986 Letter

One of my college professors revered Abraham Lincoln, seeing him not only as a remarkable leader but also placing him among the pantheon of great political thinkers.  As such, this professor enjoyed sharing anecdotes and insights gleaned from the life of Lincoln. 

I recall one insight in particular. 

Aesop's Fables was one of the few books to which Lincoln had access as a child. And so he read it assiduously for years, memorizing his favorite tales and ruminating on the meaning of each. According to my professor, the stories shaped Lincoln as he carried the morals with him throughout life. But perhaps more importantly, Lincoln internalized the practice of narrow-yet-deep reading in which he allowed his mind to fumble through the many layers of nuance in what he read, struggling with the material in an effort to internalize its lessons and understand it at the deepest level.

The professor urged us to develop the same skills, assigning us the task of writing papers on the briefest excerpts from Plato, Thucydides, or Montesquieu. We were not allowed to go to other sources for hints at what the philosophers might have meant. Our job was to struggle with the original text, fumble through the possibilities, and dig deep to explain its meaning in our own words. 

This was torture! My skill - refined by much practice - was making a cursory run through the material, pulling in quotable commentary from published scholars, flowering my prose with SAT vocabulary words, and punching the essay home with a nice summary. I became quite good at writing long papers with very little actual thinking required.   

I still struggle with going deep. My attention span still prefers wide-and-narrow reading versus Lincoln's narrow-yet-deep approach. But every once in a while I'm pulled back to learn and re-learn from old pieces. So, without further ado, here's the segue...

Buffett Defines Owner Earnings (1986)

If ever there were a single piece of valuation wisdom worth revisiting again and again to internalize its lessons, it just might come from Warren Buffett's 1986 Letter to Shareholders in which he outlines the case for owner earnings versus those required by GAAP reporting. Berkshire Hathaway's purchase of Scott Fetzer provides the example. (Scroll to the appendix, entitled Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy.)

Buffett writes:   
If we think through these questions, we can gain some insights about what may be called "owner earnings." These 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. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c).
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."
...Most managers probably will acknowledge that they need to spend something more than (b) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists - that is, when (c) exceeds (b) - GAAP earnings overstate owner earnings. Frequently this overstatement is substantial...
..."cash flow" is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, (c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment - or the business decays.
When one first reads this passage, one is tempted by the variables. One is eager to plug them into a simple formula, the values for which one might pull straight from an accounting statement. One hopes the quick calculation yields the secret of the true value of the business.

Owner Earnings = (A) Reported Earnings + (B) Various Non-Cash Charges - (C) Capex and Working Capital Necessary to Retain Current Competitive Position 

(A) and (B) give one much hope. But alas, (C) is confounding. It requires tremendous knowledge of the business and the economics of the industry to come up with even a reasonable guess of that value. Even managers of the company can be very wrong when trying to determine what portion of the earnings must go back into the assets or working capital just to keep the business from losing ground.

Owner earnings are those that are available to be plowed back into the business in order to create even more earnings in the future (capital investments, investment in expense infrastructure, or acquisitions) or paid-out (dividends, share buybacks, debt repayment) to shareholders.  They are the only portion of earnings that provide economic value to owners! If you owned the business outright, they are the portion you can strip from the business for different purposes while remaining confident you have left enough that it keeps laying golden eggs for you year after year. 

In his 1984 letter, Buffett calls these unrestricted earnings. In essence, the managers can use their discretion when deciding how to use this money without fear of injuring the competitive position of the business. 

By way of contrast, restricted earnings - which are the same as (C) and which Buffett calls ersatz* - cannot be pulled out of the business without causing damage. (It's like running to stand still. By continuing to reinvest the restricted earnings, the prize is standing your ground...not ceding market share to your competitors; keeping earnings at the same level as today. But if you don't reinvest, your business decays over time.) 

The trick, for managers and investors alike, is figuring out what portion of capital expense and/or increased expense structure is needed to maintain the current earnings versus how much is going toward promoting earnings growth in the future.   


Amazon.com In This Context

In a previous post we noted that Amazon.com is being criticized that its torrid pace of revenue growth has not been matched by proportional earnings growth...at least not over the past few quarters. Its expenses are soaring as it leans into its growth and into shoring up its competitive position in key markets.

This is the question I want to explore...

Is Amazon increasing its spending - and thereby reducing its profits today - because

1.) It has no choice and is acting out of defense to preserve the current stream of earnings? In other words, Amazon has increased its spending in order to hold off competition and maintain market share. If it weren't investing in price reductions, subsidized shipping, content, engineering talent, etc. competitors would be stealing customers, market share, etc. 


2.) By design, it is on the offensive? It's making investments in gaining market share or otherwise strengthening its competitive position with the objective of expanding earnings in the future?

We'll consider those questions next.

*Ersatz Earnings...Restricted vs. Unrestricted (Buffett's 1984 Letter)
...allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.
The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let’s call these earnings “restricted” - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential...
...Let’s turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business.
This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.


  1. I have read the 1986 Buffet letter and various formulas and explanations. By far this is the best conceptually.

    Any ideas how to interpret Buffet's "additional working capital" comment? I interpreted the conservative way. Let's say Working Capital = Current Assets - Current Liabilities. If last year WC = 1000 and this year's WC = 1200. And the net change is 200$, this should be subtracted from the Net Income by including along side with maintenance capex.

    Is this right or what is your take on this?

    1. Thanks for the kind comments. You're take is probably as right as any attempt to assign formulaic precision to a manner of thinking that is just never too precise. Working capital is about the expense infrastructure. Are expenses growing faster than revenue? If so you need to understand why. For Amazon, it'd reasonable to conclude that the expense growth is an example of plowing resources (that would otherwise be profits) into expenses for growth. You now must evaluate Amazon's competitive advantages and prospects for economic profit in the future to decide whether those plowed back dollars were worthy investments in expanding working capital. A formula will never tell you that. It requires that you think hard about the particulars of the business.

      Thanks for the question. By the way, all new updated are at my new consolidated site, pauldryden.co

  2. @Paul Dryden: Nice explanation

    @tmbsundar: WC change = 200 in your example. You need to figure out what percentage of the 200 was for maintaining the competitive position + unit volume and what percentage was for "growing" the business. As Buffet states in LIFO method, "usually" the WC won't increase if unit volume remains same.