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Jul
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In Part I, we looked at Shareholder Equity as the first step in calculating the value of a company. Shareholder Equity essentially tells us how much our company is worth if it shut down operations, sold off its assets, paid its debts, and distributed the cash to the shareholders. Though Shareholder Equity tells us the "wind up" value of the company, we do not expect our company to, well, wind up its operations.
Thus, we need to know its intrinsic value—our company's value as an ongoing business. Once again, as always, we turn to Warren Buffett for advice.
Intrinsic Value Revisited
A quick refresher on the definition of intrinsic value by Warren Buffett, with highlighting added by me:
Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.
Intrinsic value is the "wind up" value—cash we get when the company shuts down—plus any future cash that our business can generate, which can then be distributed to us or plowed back into the company to generate even more cash.
Owner Earnings
In his 1986 Letter to Shareholders, Warren Buffett defined the term "owner earnings"—the cash that is generated by the business' operations, regardless of the earnings the company reports to Wall Street. Mr. Buffett:
...we consider the owner earnings figure, not the GAAP [earnings] figure, to be the relevant item for valuation purposes—both for investors in buying stocks and for managers in buying entire businesses.
The owner earnings calculation tells us whether or not our business could survive, and thrive, on its operations alone, or if it constantly needs to find alternative sources of cash (selling stock, taking on debt, etc) to grow. In addition, owner earnings are essentially our earnings—the amount of cash our business can use to pay us or fuel growth.
Understanding Owner Earnings
Mr. Buffett, how do we determine owner earnings?
[Owner earnings] 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.
(Don't worry—it is easier than it sounds. In 1986, it was fairly difficult to obtain information. Today, it is all right at our fingertips with a click of the mouse.)
Reported Earnings (the earnings Wall Street adores) plus Non-Cash Charges (tax write-offs that did not actually require cash) minus Capital Expenditures (the cash the business must spend to keep product pumping off the assembly line, so to speak).
Think in terms of your personal finances: You (a) report certain income to the IRS for taxes, you (b) get certain allowed write-offs, even if they didn't cost you a dime in cash, and you (c) have to repair or replace your car every few years to get to and from work—"expenditures" that don't show up anywhere on your tax return but still eat up your cash. Your "reported" income on your tax return says one thing; your "owner earnings" probably tell a much different story.
Finding The Information
Before you throw your hands in the air, decide it is too difficult and "math-y", and skip to a site offering the next "hot stock tip," I'll let you in on a secret—somebody has already done the work for us. Still, follow me through an example so you can understand where the numbers come from and how to do it yourself. Then, I'll tell you where to find what you need.
We start with the Statement Of Cash Flows—an accounting report that companies must submit to the SEC along with their annual reports. Broken down into three sections, the Statement Of Cash Flows tells us (1) how much cash the business generates (or eats) From Operations, (2) how much it generates (or eats) From Investing Activities, and (3) how much it generates (or eats) From (external) Financing.
As is, Buffett called these reports "absurd" because the Cash Flow From Operations does not include the capital expenditures the company has to spend on property, plants, machinery, and equipment (item c in Buffett's calculation). Capital expenditures are listed under the heading "Cash Flows From Investing Activities" for some reason. To quote Buffett:
Why, then, are "cash flow" numbers so popular today? In answer, we confess our cynicism: we believe these numbers are frequently used by marketers of businesses and securities in attempts to justify the unjustifiable (and thereby to sell what should be the unsalable)...though dentists correctly claim that if you ignore your teeth they'll go away, the same is not true for [capital expenditures].
To calculate owner earnings, you must rearrange the "absurd" to make it "rational." Let's look at the famous Johnson & Johnson valuation valuation that so many thousands have enjoyed.
Calculating JNJ's Owner Earnings
At the end of 2006, Johnson & Johnson reported to the SEC $14,248 million of "Net cash flows from operating activities"—the basis for our calculation. If you look under "Cash flows from investing activities," you'll see that JNJ also spent $2,666 million on "Additions to property, plant and equipment" without which JNJ could not produce its products. Ready for the hard part?
Subtract $2,666 from $14,248—you have $11,582 million in owner earnings for 2006. "Wait," you say. "Buffett says we should use the average annual amount to find owner earnings!" Right—which is precisely why we don't judge a business on one year of performance and we analyze companies using many multi-year timeframes. But that's part of the discussion for Part III.
And Here's The Cheat
I keep referring to Morningstar's site as a source of research. Believe me—I am not in any way affiliated with them and I am not a big fan of mutual funds for most investors. Still, I have to keep going back to them because they've already done a lot of the heavy lifting for us.
This link will take you to Morningstar's Cash Flow report for Johnson & Johnson. Change the ticker and you'll find reports for thousands of companies. At the bottom of the report is "Free Cash Flow". Voila!
Other Posts In This Series
Calculating The Value Of A Business - Part I
Calculating The Value Of A Business - Part III
Calculating The Value Of A Business - Part IV
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by Tiago on July 20, 2007 at 7:40 AM