I am finding that the changes in working capital on some companies radically alter the cash flow valuation. The owner earnings can seem way higher than the FCF as a result. Therefore I feel it’s important to totally understand these figures before investing. I could be missing out on some hidden earning power! Hence i have a question for anyone who has mastered this ?

Going back to Buffet’s owner earnings definition, much cited (in a range of wildly fdifferent contexts it seems!) he states…

(If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)

Regularly i find companies with great cashflow statements yet worrying red areas in the Accounts Recievable/ Inventories/other assets section. If you valuate them as FCF the results are low but using Owner Earnings without ‘changes in working capital’ they appear to be earning much more. But did Buffet actually recommend taking out the CWC? Should i do so without knowing exactly to what they refer?

Perhaps I am to take an average of these values and factor these into the capex?

Or am i generally safe in assuming that as they are ‘in flux’ they are ultimately impossible to value and should be ignored?

What if, for example, the company continually doesn’t get it’s bills paid (accounts recievable) ? Or if inventory is always low? Does this mean, in Buffet’s terms, that ‘unit volume is not consistent’?

Or, if everything else is ship shape, can we safely ignore the changes in working capital?

Any help would be super helpful!!

It depends on how the company recognizes revenue. Many companies recognize revenue at the point of sale as Joe pointed out, though some recognize it at delivery and some when cash changes hands. What’s beautiful (in my opinion) about Joe’s book is that he makes you think about these things, unlike almost every other investment book I’ve read. (It’s like a “Security Analysis for Dummies” book.) I don’t think Joe once said, “Buy low PE stocks.”

I paused when I read the capital expenditures part too. For future editions, Joe may want to clarify for us analytical types. As he seems to really know his stuff, I assumed that he wasn’t talking about painting a machine or recaulking a seal but about upgrading or otherwise extending the life of machines and equipment. Without a background in accounting, someone may not come to the same conclusion as I did.

I think that BPal and I may have looked at the text a little to critically, but Joe could have clarified a bit as well. I wouldn’t say he got the accounting “wrong” so much as I’d say that the accounting is a little basic for CPAs. Still a must read for everyone in my opinion, and I learned a lot even with my background in accounting.

Also, the next section covers expenses and talks about $10,000 in repairs to equipment that get capitalized on the balance sheet and amortized. This also isn’t exactly correct. The accounting rules would not allow repairs to be capitalized. They are expensed as incurred. Only new purchases, construction costs (if the equipment is built in house), or items added to existing machinery that improves its value can be capitalized, not repairs. I think you were trying to highlight maintenance capex versus growth capex, but you got some of the exact accounting wrong.

I am very interested in getting my hands on this report, but I see that the link directs to your book. However, in your book I do not see any mention of FCF vs OE. I wanted to know how I could go about purchasing the report now.

Thanks.

Below is a link to an article on SeekingAlpha.com which I think will be of interest to FWallStreet readers.

http://seekingalpha.com/a…

Stephen

When I purchased it, Joe sent me the report within 48 hrs of purchase. If you have purchased it and haven’t received it, i wouldn’t worry, it probably means that Joe hasn’t gotten around to checking his e-mail, he seems to be a busy guy.

Enjoy the read, it’s great to have around.

IT’S WORTH THE 20 BONES! (This is a very fair price for what you get)

Cheers.