I know-Enron is old news. If you don’t remember the scandal, Enron was an energy and commodities trading company that went from massive to bankrupt in just 16 months. Once the largest marketer of natural gas in North America and the United Kingdom and the largest marketer of electricity in the United States, Enron was wrought with scandal and deception which resulted in a total loss to many investors.
Could investors have avoided the loss altogether? Can we protect ourselves from accounting scandals?
By the end of 2000, Enron was on top of the world. Its stock had hit all-time highs and revenues topped $100 billion. Everything seemed hunky dory so long as Enron and their accountants at Arthur Anderson kept cooking the books.
Price Follows Value
Throughout 2001, the stock began falling from its $90+ highs, all the way down to $1 a share. On December 2, 2001, Enron declared bankruptcy. Soon after, the SEC uncovered accounting scandals and flat out lies from both Enron and accounting firm Arthur Anderson. Investors lost billions…but it could have been avoided.
If you had looked at Enron’s owner earnings from 1994 to 2000, you would have never been burned. In fact, you would have never invested in the first place. (Unless you were an Enron employee who had no choice but to own Enron stock in your 401k)
Forget Accounting, Follow Cash
Even using Enron’s cooked income, you could have spotted the Enron problems long before they happened. After all, it is fairly easy to manipulate net income for Wall Street and the IRS. But, cash is cash, and it is hard to say that your bank account has an extra $1 million when the statements clearly show that it doesn’t.
Take a look at Enron’s owner earnings from 1994 to 2000:
| in $Mil | 1994 | 1995 | 1996 | 1997 | 1998 | 1999 | 2000 |
| Net Income | $ 453 | $ 520 | $ 584 | $ 105 | $ 703 | $ 893 | $ 979 |
| Depreciation & Amortization |
441 | 432 | 474 | 600 | 827 | 870 | 855 |
| Changes In Balance Sheet |
-142 | -834 | 142 | -65 | -233 | -1,000 | 1,769 |
| Capital Expenditures |
-661 | -731 | -855 | -1,413 | -1,905 | -2,363 | -2,381 |
| Owner Earnings | 91 | -613 | 345 | -773 | -608 | -1,600 | 1,222 |
Not only did Enron burn through $1.9 billion of cash, they had just three positive years out of seven. Even if you thought that 2000 was the turnaround and that Enron was on track to rapid growth, you still couldn’t buy.
A Random Guess at Value
In 2000, Enron produced $1.22 billion of owner earnings-the first positive year in four. Using pure speculation (I hate to do it, but I will), let’s assume that Enron would have grown 15% a year for the next ten years, and then slowed to 5%. Sure, there’s no basis for our reasoning, but let’s forge ahead.
Using the above assumptions, Enron would have been worth $60 a share using a 9% discount rate. With a 50% margin of safety, we couldn’t buy Enron for more than $30 a share, and certainly not at $90.
By the time Enron dropped below $30, the reports of scandal were coming in. If you can’t trust the financial statements, you can’t own the business-and you would have gotten out as fast as you had jumped in.
Where Was Wall Street?
Allow me to steal a quote from this Forbes article:
Major Wall Street analysts listened intently to the story and few questioned it. As of [October, 2001], 13 analysts covered the company. Eleven recommended it as a “buy” or “strong buy.” Just one said “sell” and the other said “hold.” This was just one week before the roof fell in, and Enron announced it would sell itself to Dynegy, its crosstown rival.
And those are the firms and people overseeing the financial futures of millions of Americans.
Accounting Scandal?
If you played Wall Street’s game, you would have been surprised, and outraged, by Enron’s accounting scandal that wiped the company off the face of the earth. If you invested like a business owner and used data and reasoning to calculate an intrinsic value, you never would have bought it in the first place.
Can we protect ourselves from accounting scandals? Not entirely. But I’m a gambling man (in Vegas at least) and I’d be willing to bet that we could avoid 99% of all scandals long before they shock Wall Street and crush the mutual funds. Why? They trade stocks; we own businesses.
And that will forever give us the edge in the long-term.
Filed under: Companies Analyzed (Generals)
Nick,
There are two ways to calculate owner earnings. The “easy” way is to subtract capital expenditures from Net Cash From Operations. The difficult way (I call it the “raw owner earnings”) is to calculate Net Income + Depreciation & Amortization + Changes in balance sheet items (non-cash charges) – Capital Expenditures. In a wonderful company, the two will be extremely close – so close, in fact, that using either one will give you a similar enough valuation and confidence.
Which one is best? It depends on what you want to project for your business. If you want to know the raw earning potential of the operations, you would find the raw owner earnings. If you want to figure out the value of the business including the effect future stock options, tax benefits, etc. would have on your business, you would use the “easy” formula.
As far as changes in the balance sheet, the Cash Flow from Operations has a section that reconciles the balance sheet based on cash. That allows us to turn accrued revenues or expenses into actual cash charges. It doesn’t necessarily show changes in shareholder equity because loans taken out by the company which might affect shareholder equity aren’t included in owner earnings.
There are a number of different ways to value a business. So long as they use the proper data, are rational, and come to relatively the same conclusion, no one is better than the other. Where you get burned is when you rely on a system that works on some businesses or in some markets, but not others.
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Dave,
When a company spends cash, it first uses the cash generated by operations. Once that cash is gone, it has to start burning through its reserves/bank accounts. That cash comes off the balance sheet and needs to be included in (or reduce) owner earnings.
If you don’t account for that cash reduction, the shareholder equity and assets will slip away and you’ll never notice it – until it is too late. If the company can’t generate enough cash from operations, it will literally eat itself away into nothing.
So, to answer your question: Yes, I include (sum) the changes in cash, receivables, inventories, etc. to reconcile the cash generated with the balance sheet.
Hope that helps!
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Thanks for the heads up on fraud detection. I’ve been burnt too many times by fraudulent managers. Another question, in the case of outright fraud (in this case abetted by the auditors) can the inventories & receivables and even the revenue/income numbers be trusted?
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Dave: The business’ FCF is generated from operations – regardless of the number of shares. Where the shares come into play is if your investment – your right to or chunk of ownership of FCF – is being diluted, essentially decreasing in size even if its value is increasing.
If a company is widly issuing grants without repurchasing stock, dilution can get out of hand. If the company matches that with open market share repurchases, it is somewhat of a wash because the company could have just cut a check to the employees.
Because stock options are now expensed (reflected in net income), that will appear in your owner earnings. Before June 2005, that was not the case as GAAP didn’t require options to be expensed.
Nelson: In the case of outright fraud, nothing can be trusted. Fortunately, owner earnings usually detect fraud before it gets to the point of fraud. That is, when a company can’t generate enough cash to keeps its operations going, it may turn to fraud. But, when a company is operating successfully, it has no reason to operate or report fraudulently. Any such fraud is usually minor as opposed to Enron-style, major fraud.
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Russell,
Net income is an accounting standard; cash flows track the actual flow of cash through a business. Think of it in terms of your personal finances. More likely than not, your annual tax return does not take into account all of your daily spending and is not an accurate reflection of your personal wealth and financial well being.
On your tax return, for example, you may be able to deduct mortgage interest on your home, but not your principal payments. Though your tax return might show a relatively high (or pretty) net income (net of mortgage interest), if you aren’t generating enough cash to pay your mortgage, you’ll be out on your ear in no time.
Tax returns and net income are for accountants and the IRS; cash flow is for investors. Make sense?
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Damn PEOPLE! You outta check out GARDA WORLD (GW.TO).
Another example of Bad business.
See what happened to the stock price after years of negative FCF and bad management.
a)there’s actually A POST ON GOOGLE FINANCE FROM SENIOR MANAGEMENT trying to defend its bad business practices saying it is “the economy’s fault completely”.
b)Somehow those 18 acquisitions in 12 months had nothing to do with it and they were successful making those acquisitions.
c) they are selling those acquisitions now because they have too much debt and their interest costs went up(debt they got for acquiring those companies). Classic example that fits analogy on Citigroup.
d)In the beginning of the year, one of senior management of its Security Division quit because he said that the CEO is hiding the reality of the numbers presented through GAAP.(Accounting Scandal)
e)To give you a picture: Insiders have even been selling ALOT when the stock was 20$ and it is now 1.40$. (how can he be true partners with shareholders if he’s selling??)
You were so right about the CRONIES on Wall-Street but they are also there in TSX.
What’s alarming is that you can clearly see that the senior manager has no clue what the hell is going on! (he actually took the time to tell the poster that he’s heavily invested in the company because recent troubles are SOLELY the economy’s fault. Isn’t that troubling that HE’S MANAGING OUR MONEY?)
My neighbor follows Buffet’s teachings(he likes your blog), TYLER let me know and I was just BLOWN away when I read the lively discussion but everything the other posters have said seems true.
I wonder what you all think
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If a company is widly issuing grants without repurchasing stock, dilution can get out of hand. If the company matches that with open market share repurchases, it is somewhat of a wash because the company could have just cut a check to the employees. you can get more information from this,
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Hey Joe. I am somewhat confused in your owner earnings calculation. You say that you use Buffetts owner earnings formula as your basis for valuation but your formula seems a bit different than what he explained in his 1986 shareholder letter. After reading your book and articles from this site your formula seems to be the following: Net Income Depreciation/Amortization Changes in Working Capital – Average CapEx versus Buffetts: Net Income Depreciation/Amortization Other non-cash charges – Average CapEx (If the company requires additional working capital to maintain its competitve position and unit volume, then include this in Average CapEx). Are the changes in working capital from the cash flow statement the same as non-cash charges? In Buffetts 1986 Letter to Shareholders he provides an example of Scott Fetzer and he points out the specific non-cash items he adds in to get the owner earning earnings of the company. He doesn’t include changes in working capital in the formula. This is where I am confused. I am by no means an expert in finance or investing; I am still learning. I just need some clarification. Warren Buffett said:
“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 such as Company N’s items (1) and (4) 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) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)”
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Joe,
I assume that changes to the balance sheet simply means an addition or subtraction from shareholder equity. Is that right?
While we’re on the subject, up to this point, we’ve just been subtracting CapEx from operating cash. Now you mention adding back d/a to net income instead of cash from operations and any changes in the balance sheet. Which one’s best? Are their different situations that call for each?
Thanks
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