Just to be clear, Joe is talking about owner’s earnings growing at 23.9%, not owner’s equity. Owner’s equity, over the long term, should trend along at the same rate as the increase in owner’s earnings. This is, of course, what we hope to achieve as investors.

As far as FCF and owner’s earnings being referred to interchangeably, they are actually referring to the same thing as far as this blog is concerned. Joe is using FCF, which is simply cash from operating activities – capital expenditures. This is to keep things simple and consistent.

Hope that answers your questions.

With Wal-Mart, we had to separate the growth capital expenditures from the maintenance ones to get a better look at true cash flow. Check out this post where I explain it.

Hope that helps!

I just want to say that I really like your site. It is very informative, and as a new investor I am finding very useful. I didn’t understand how you got growth in owners equity growing at 23.9% (as you say half what it actually has been historically). I believe that you use FCF and owners earnings interchangably. I had a number closer to 4%. Any help (from anyone) would be greatly appreciated.

Vince

Owner earnings & CapEx

When CapEx exceeds Depreciation, GAAP earnings are generally higher than Owner Earnings. When Depreciation exceeds CapEx for long periods, the company is essentially suffocating itself. Over the long-term, Depreciation and CapEx should be roughly the same. Still, in the short-term, the two can vary greatly – and often do as major purchases require a huge cash outlay (CapEx) with a scheduled, and smaller, Depreciation write-off.

Owner earnings normalize balance sheet/working capital changes – unless they are minor and insignificant. When you subtract CapEx from Net Cash From Operations, you are considering and accounting for the changes to working capital – changes in the balance sheet.

Focusing on FASB Rules

There is nothing wrong with focusing on FASB rules and calculations – either as your sole or primary means of evaluating a business. There are, in fact, many ways to value a company.

I try not to focus entirely, or even primarily, on FASB rules for accounting. To some, that will undoubtedly go against everything they’ve learned and/or believe. Am I right? Wrong? Again, there are different ways to do things and none of us are entirely right or entirely wrong. No matter how much we/you/I try, some people will never understand this reality and will fight tooth and nail to prove everyone else wrong.

Later in that 1986 letter, Buffett did say:

Questioning GAAP figures may seem impious to some. After all, what are we paying the accountants for if it is not to deliver us the “truth” about our business. But the accountants’ job is to record, not to evaluate. The evaluation job falls to investors and managers.

Accounting numbers, of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress. Charlie and I would be lost without these numbers: they invariably are the starting point for us in evaluating our own businesses and those of others. Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it.

The lesson here: Don’t focus entirely on FASB rules, and don’t ignore them entirely. Use them to enhance your evaluation.

Leverage

Certain forms of leverage are great; some leverage can be devastating. To run from a business because it is leveraged, or to buy because one is not, is silly. The question is: Is management using that debt to enhance growth or is the debt an indication of harsh times to come?

I don’t think it is rational or fair to compare Berkshire’s debt to Wal-Mart’s – that is comparing apples to oranges. Chugst is right – debt holders have a first claim on the liquidation of the company and are first in line to receive owner earnings. If Wal-Mart can’t manage its debt, that becomes a serious concern. So, can Wal-Mart handle its interest payments and manage its debt?

That depends on which side of the fence you are on. If you are a Wal-Mart doomsdayer, then you’ll believe it can’t and think the company is in trouble. If you think that Wal-Mart is a strong enough business to keep consumers coming through the doors in good and bad times, you may be fine with Wal-Mart’s debt.

We’re All Right

Nobody is right or wrong here. You have to look at the business. You have to predict the future. And you have to be comfortable with your company. If you can’t do that, move on to another company.

Robert is especially right: P.T. Barnum is not dead. Right now, a sucker is buying or selling Wal-Mart. Only time will tell who was on the right side of that trade.

Love The Discussion!

The discussion here is great. Let’s try and keep the insults and bickering to a minimum. Hidden agendas too (for those that are running all around the web bashing Wal-Mart on forums).

Let’s post and comment to help each other, not bash, insult, or prove each other right or wrong.

1. BH’s debt is different from WMT’s because BH is in the insurance business. This was a strategic choice by Buffett. He wanted to be in the insurance business because the debt / member premiums not only allowed him to take the proceeds and invest them, but, in fact, the very model of insurance required it. In other words, insurance played to his strengths as an investor. WMT is not in the insurance business, and, consequently, the logic going in is different … denying the use of divergent logic coming out (if seeking consistency). By the way, Buffett repeatedly addresses the issue of risk exposure attributable to BH’s insurance holdings in his annual reports — suggesting that other investment opportunities exist for those not comfortable with them:

“All things considered, we believe our worst-case insurance

loss from a super-cat is now about $600 million after-tax, an

amount that would slightly exceed Berkshire’s annual earnings from

other sources. If you are not comfortable with this level of

exposure, the time to sell your Berkshire stock is now, not after

the inevitable mega-catastrophe.”

(http://www.berkshirehathaway.com/letters/1994.html).

2. Buffett has primarily argued against long-term debt — making the distinction between long-term debt and short-term debt. The reason this is important is that it is difficult to know or predict the availability or cost of renewing long-term debt or predicting the costs associated with interest rates. If a firm enters into a long-term debt obligation at a relatively low percent but needs to finance sustaining debt as principle is payed in, its cost will increase if interest rates rise. If Wal Mart’s debt is a one-time thing and does not require repetition, there is no problem. If, however, the company requires such debt to deliver shareholder-required returns, it can not renew that debt at higher cost without undermining your investment.

There is, moreover, the uncertainty associated with availability of debt in an increasingly uncertain environment — declining dollar, expanding international investment opportunities, and the host of issues associated with international trade, terrorism, the US trade deficit, government funding short-falls, inflation, etc. All of these make long-term debt a more uncertain proposition in the US â?? and, to varying degrees, elsewhere.

In an earlier time, Graham advocated dividing long-term debt by net earnings or free cash flow to determine the pay-back period. If debt pay-back extended beyond a couple of years for average firms, he believed the risk was too significant. For strong, well-managed, firms, with proven and sustainable cash flows and profitability, 5 years was the maximum threshold, if memory serves. For WMT, this is 3.69 years (LT Debt / Cash & Equivalents).

3. I understand the Japanese interest rate argument … it is called arbitrage — i.e., benefiting from pricing disparities between two markets. That is different from leverage. For example, liarâ??s loans, 80/20â??s, and sub-prime loans constituted leverage and the risk associated with it for the home buyer. They (the buyers) were counting on a slowly rising level of interest rates and home-price appreciation sufficient to refinance in advance of resets. The mortgages, of course, were long-term loans, and the environment moved against them (rates increased more rapidly and extensively than expected, the housing market became glutted, the variation between LIBOR and the Fed Funds rate grew, and the re-fi’s failed to materialize). In other words, these buyers took on excessive *long-term-debt risk* through leverage.

At no time were they arbitraging interest rate disparities or spreads between coverage periods. What they were doing was buying more home than they could afford and increasing their downside risk exposure if the market moved against them. These are the very risks I mentioned when describing the negatives of “leverage,” and the same principles apply to firms as to our neighbors facing foreclosure.

Archimedes said that, with a fulcrum and a sufficiently long lever, he could move the world through leverage. What he didn’t describe was the crash that would follow if the fulcrum crumbled or the lever snapped.

4. As for Wal Mart, I don’t know the answer. Buffett likes the company, but it doesn’t make the cut when I look for firms selling at a significant discount. The debt structure may make sense for WMT, but I doubt it. The key differential advantage for WMT is the ability to provide inexpensive products, produced in lower-cost countries, sold to cash-flush Americans. [WMT's success outside of the US has been less than expected or hoped]. Both assumptions strike me as potentially flawed.

First, the product-producing countries (India and China, especially) are benefiting from growing trade, and competition for quality workers is expanding wages in emerging market countries. This increases production costs, which may be passed along to the consumer and accepted or rejected by him or her.

Second, the declining dollar makes imports more expensive. Commodity prices (oil, as well as milk and eggs are commodities â?¦ to say nothing of pork bellies) are rising, health care costs are growing at three times wages, and home financing is uncertain — as defaults expand and the glut persists. Given this, the cash-flush US consumer represents an uncertain wager in the short- and medium-term. Which is precisely when the burden of long-term debt is most challenging. Greenspan claims the prospect for a recession next year is roughly 40 percent. Economies, however, are cyclical and, after more than 5 years of expansion, this time may not be different.

None of this targets WMTâ??s debt, directly. By my estimates, WMT is growing long-term debt by $2.2 bil, yearly, short-term debt by $4.098 bil, and total liabilities by $6.9 bil. This level of debt is powering total asset growth of $11.6 bn, but increasing cash and equivalents by just $6.86 mil and total current assets by $3.03 bil. All of these are based the Morningstar figures, and the growth rates apply linear trending regressions with R-Squared values in excess of 0.9 (1.0 represents a perfect fit).

In other words, WMT is financed more like a growth stock than a value play. This approach works in a growing market but may be problematic if the market declines. At just 7 percent over the past 5 years, both, EPS and shareholdersâ?? equity growth falls well below my threshold of 15 percent (which Hagstom believes is WBâ??s threshold, as well). Ownerâ??s Earnings, at -4.89 percent and -3.81 percent for the last decade and five years, respectively, fails to strongly urge purchase of the stock at these prices, based on Buffettâ??s reputed threshold.

Finally, Mark Twain maintained that it is the difference of opinions that makes horse races. Far be it from me to suggest that Wal Mart is not a great investment. All I know is that, unless the price declines or WMT evidences sustainable grow rates beyond its historic norm, I won’t be on the other side of the trade when you sell. This should not be a problem, however. We have a liquid market, and, despite rumors to the contrary, P. T. Barnum is not dead.

The numbers I’ve used are AUDITED fiscal 2007 numbers per FASB #95 via the statement of cash flow.

>Depreciation is not a cash outlay. It is for tax purposes. Owner earnings

are net cash generated minus non-growth Capex spending. CROIC analyses

the efficiency of debt financing and is the basis for owner earnings growth.

To avoid any more confusion, I’ll just quote Warren Buffet from his 1986 Letter to Shareholder regarding owners earnings and the relation of depreciation and capex:

“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.)

…

That is obviously a happy state of affairs. But calculations of this sort usually do not provide such pleasant news. 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. The oil industry has in recent years provided a conspicuous example of this phenomenon. Had most major oil companies spent only (b) each year, they would have guaranteed their shrinkage in real terms.”

The operative phrase is ” when (c) exceeds (b) – GAAP earnings overstate owner earnings” — here WMT’s Capex (the “c” referenced by Bufffet) dwarfs Depreciation expense (the “b” referenced by Buffet) by about $10 billion in fiscal 2007, it is a BIG red flag! Why you ask, because WMT has been using VENDOR financing to support the growth in Inventories in fiscal 2007 in the tune about $1B. Had the relationship between inventories and accounts payable gone the other way, WMT’s owner’s earnings would have gone down $2 B. Joe NEVER normalized the working capital portion of FASB 95 in order to get to cash flow operations; therefore, Joe’s statistics OVERSTATES owners earnings. The fact WNT’s debt balances increases also gives strong evidence that earnings + DDA were insufficient to fund Capex.

With respect to the issue of Debt, here’s what people fail to recognize. When Warren Buffet messed up on his US Air investment, Buffet wrote:

“When Richard Branson, the wealthy owner of Virgin Atlantic Airways,

was asked how to become a millionaire, he had a quick answer: “There’s

really nothing to it. Start as a billionaire and then buy an airline.”

Unwilling to accept Branson’s proposition on faith, your Chairman decided

in 1989 to test it by investing $358 million in a 9.25% preferred stock of

USAir.

I liked and admired Ed Colodny, the company’s then-CEO, and I still

do. But my analysis of USAir’s business was both superficial and wrong.

I was so beguiled by the company’s long history of profitable

operations, and by the protection that ownership of a senior security

seemingly offered me, that I overlooked the crucial point: USAir’s

revenues would increasingly feel the effects of an unregulated, fiercely-

competitive market whereas its cost structure was a holdover from the

days when regulation protected profits. These costs, if left unchecked,

portended disaster, however reassuring the airline’s past record might

be. (If history supplied all of the answers, the Forbes 400 would

consist of librarians.)

To rationalize its costs, however, USAir needed major improvements

in its labor contracts – and that’s something most airlines have found it

extraordinarily difficult to get, short of credibly threatening, or

actually entering, bankruptcy. USAir was to be no exception.

Immediately after we purchased our preferred stock, the imbalance between

the company’s costs and revenues began to grow explosively. In the 1990-

1994 period, USAir lost an aggregate of $2.4 billion, a performance that

totally wiped out the book equity of its common stock.

For much of this period, the company paid us our preferred

dividends, but in 1994 payment was suspended. A bit later, with the

situation looking particularly gloomy, we wrote down our investment by

75%, to $89.5 million.”

Ouch, a $358MM investment written down to $89.5MM. When a company has a lot of debt, some of that owner’s earnings that Warren talks about goes to debt holders rather than the owners.

So my message to Joe is that since WMT is increasing it debt balance, other things being equal, there’s less money goes to the equity (on top of $10 B deficient between Capex and depreciation for fiscal 2007!).

Lastly, someone wrote: “Dollar for dollar, Berkshire would (according to Chungst) be at greater risk for failure, slowed growth, or hard times. And by Chugst’s methods, Buffett is (intentionally?) lowering Berkshire’s owner earnings because it has “significant debt.”

I never stated that position. I have always stated that you have to look at the economics, for example, while deferred taxes may be a liability account item on the balance sheet, it can act like equity and this really confuses people. Buffet’s insurance firms enjoys the benefit of “float” and that is not the case for WMT. TBadd should NOT put words in my mouth if s/he doesn’t understand my position.

> If $33.8 billion of debt was a concern and strain, I don’t think he’d do it.

It’s more when you consider the off-balance financing that WMT has. TBadd, I STRONGLY recommend that you read footnotes #8 and #9 from WMT’s audited financial statements.

TBadd et al, I never stated whether I was either long or short WMT; however, I did state I have options in WMT.

Cheers.

PS One more comment:

> Owner earnings are owner earnings no matter how much debt a company has.

Spoken by a person who fails to understand that debtholders can force a company to file for bankruptcy and THEN the debtholders now have first claims to the owners earnings and the prior (equity) owners are screwed.

oh! and Berkshire Hathaway has no “star” in the name!

Wal*Mart was able to do what Gibson’s and his son-n-law Howard’s couldn’t ….

kite fly money out of every town at 00:15…..

but that only works with…..

growth!

True. My point is that a firm with debt is not necessarily bad. If a company can borrow money at 10% and use it to generate 15%, then it should borrow as much as it can (within reason). To arbitrarily say that WMT is taking on too much debt because it went from A to B is rediculous – unless you’re in the board room.

During the Japanese 0% interest run, investors were borrowing billions in Japan and buying US treasuries – essentially earning 4% interest on money they didn’t own. They were leverage to the hilt, but it did not hurt them one bit. In fact, they made billions of dollars in interest and it cost them nothing.

Would they be wrong to do that if Japanese rates were 4% and ours were 10%? It’s all the same. If the debt is being used properly and cautiously, there is no reason to fret.

For the record, Berkshire Hathaway reported $38.2 billion of long-term debt on its June 30, 2007 balance sheet – Wal-Mart reported $31.6 billion, down from $33.1 billion three months earlier. Wal-Mart generated twice as much cash from operations.

I’m not saying Wal-Mart is better than Berkshire, and we know Buffett is a brilliant money manager. But Berkshire generates half as much cash and has more debt. Dollar for dollar, Berkshire would (according to Chungst) be at greater risk for failure, slowed growth, or hard times. And by Chugst’s methods, Buffett is (intentionally?) lowering Berkshire’s owner earnings because it has “significant debt.”

To each his own. I’m more inclined to believe that Buffett knows how to generate maximum owner earnings. If $33.8 billion of debt was a concern and strain, I don’t think he’d do it. Considering that Cash From Operations forms the basis for owner earnings, and that Wal-mart generates 4x the cash that Berkshire does, I am not concerned about its debt load.

But just because I own Wal-Mart doesn’t mean Chungst has to.