In his 1986 letter to shareholders, Warren Buffett described how he worked out what he called the "owner earnings" (referred here as cash profits) of a business. He did this because he believed the reported profits of a business were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.
Owner earnings
= net income + depreciation & amortisation + other non cash items - maintenance capital expenditure.
Buffett's view was that the amount of money a company needed to spend to maintain its competitive position (known as maintenance, or stay in business capex) often exceeded the depreciation and amortisation expense and therefore, profits were overstated.
Also, if a business needed extra working capital (more stocks, or more generous credit terms to customers), this should be added to the maintenance capex figure. Generally speaking, though, this calculation ignores changes in working capital that are included in free cash flow.
The hardest part of this calculation is trying to estimate what maintenance or stay in business capex is. As a company outsider without intimate knowledge of its assets and their condition it is virtually impossible for you to be exactly right on this.
So how do you get an estimate of stay in business capex?
There are three reasonable methods:
1. The company tells you. This figure may be in the annual report.
2. Use a multiple of the current depreciation or amortization expense. For example, use a figure that is bigger than this, such as 120%. This can be a reasonable estimate sometimes, but for some companies it can be way off if the cost of replacing assets is falling.
3. Use a 5 or 10 year average of capital expenditure or capex. This is likely to include money spent to grow a business but these assets will need to be replaced in the future and so this could provide a good proxy for cash needed to stay in business. This is a good approach to use if the company does not state the figure outright. As a rough rule, if the 5 year capex figure is higher than the 10 yr average you should use the higher figure.
Annual depreciation expense <<< average 5 or 10 year capex.
This is the case in asset intensive companies. These companies usually have very poor free cash flow track records and modest ROCE and CROCI performances. These are two good reasons against investing in them. Avoid them unless they have been able to produce a good ROCE whilst investing heavily.
Capex <<< depreciation and amortization.
Normally this kind of behaviour would make you suspicious, thinking that a company has been under-investing, which would hurt its ability to make money in the future.
On the other hand, there maybe nothing bad going on. You need to study the company's history on this issue to make sure that it is not under-investing.
Using average capex figures to estimate of cash profits (owner earnings)
If the 5 year capex figure is higher than the 10 year average, use the higher figure.
Comment: Note the key outlier is Tesco. Its cash profit is negative. If you come across a company that looks as if it is losing money when estimating its cash profits you need to either do some more research to see if you have missed something - such as the company investing in lots of new assets rather than replacing them - or look for another share to buy.
Here is the process to derive owner earnings or cash profits again:
- Use the most recent annual underlying or normalised net income/profit
- Add back depreciation and amortization
- Minus an estimate of maintenance or stay in business capex.
- From these, you derive cash profit (owner earnings)
- Divide by weighted average number of shares in issue for the latest financial year to get an estimate of cash profit per share.
Knowing the company's cash profits, you can use these to value shares. HOW?
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