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Calculating The Value Of A Business - Part II

By Joe Ponzio on July 20, 2007  |  28 comments

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

Written by Joe Ponzio on July 20, 2007

Joe Ponzio is the managing partner of the Ponzio Investors Funds and owner of Ponzio Capital Inc, a registered investment advisory and deep value portfolio management firm. The author of F Wall Street (the book and the website), his articles have appeared in hundreds of financial media, including Financial Planning Magazine, CNBC.com, Yahoo! Finance, and Reuters. He has appeared numerous times nationally on both radio and television, and has presented at universities and seminars across the United States.

Read more articles like this online at www.fwallstreet.com.
To learn more about Joe's portfolio management services, visit www.ponziocapital.com.
The Discussion
Tiago' gravatar

Tiago
Jul 20th, 2007
8 comments

Morningstar FCF equals Owner Earnings? It's the same thing?
Morningstar's FCF is roughly the same. It doesn't take into account the "average annual" capital spending. If you were looking at one particular year, then no - it is not the correct owner earnings. If, however, you are looking at multi-year timeframes, as Buffett suggests, then you would be seeing owner earnings.

Make sense?
Mat' gravatar

Mat
Jul 31st, 2007

Reading the 06 annual report, I realized that JNJ invested roughly $18B in acquisitions. It seems to me that ignoring the cost of acquisitions is ignoring the fact that they buy whatever patent or technology from small firms instead of developing them (read investing) in-house. The acquisitions are then essential just like CAPEX to keep the business going; ignoring them could be costly.

According to Morningstar data, JNJ never invested more than $3.4B a year on acquisitions over the past 10 years. Again over the past 10 years, subtracting the average capital invested from average FCF reduced the "real" FCF by about 40%.

So the question is: Do you believe JNJ will continue to spend as much on acquisitions and will they pay a fair price? Given the recent spree of M&As and sky high prices, I'm skeptic about the quality of the investments made.

What do you think?
Hi Mat,

I don't include M&A in the calculation because I try to get the raw cash that JNJ could produce if it couldn't acquire businesses, sell stock, or take on additional debt. Their past acquisitions have all contributed to the growth in owner earnings, and we can only hope (and track) whether that growth can be sustained.

If JNJ can't buy anything next year, it will still likely produce more cash than it did last year. Unfortunately, all we can do is buy the cash—it is up to management to figure out what to do with it.

Is management rational with shareholder money? It seems so. CROIC is high, owner earnings are growing. Will that continue in the future? We can't be certain, which is why we need that margin of safety.

I understand exactly what you are saying, but I think a better candidate for concern would be Alcatel-Lucent. With no predictability in the numbers and a constant burn of cash, ALU's acquisitions seem more like an attempt to fix a failing (or difficult) business than to increase shareholder value.

My two cents.
mm' gravatar

mm
Sep 19th, 2007

Perspectives on the Cash Flow Statement .
http://www0.gsb.columbia.edu/ceasa/policy/occasional_papers.htm
Sanjay Shetty' gravatar

Sanjay Shetty
Oct 26th, 2007
24 comments

Hi Joe,

One reads so much about manipulation of a companies reported numbers, cashflow as well... what should one watch out for, to check for free cash flow manipulation if any.

Regards,

I blog at: http://indiainvestor.wordpress.com
E' gravatar

E
Nov 27th, 2007
2 comments

Hi,

I have a question about capital expenditures. What should be included in the capital expenditures calculation? I looked at The Volvo Group for example, and they have "Investments in fixed assets" and also "Investments in leasing assets". When calculating capital expenditures, is it only the "Investments in fixed assets" that should be included, or both of them?

In the annual report from 2006, in note 7 to the consolidated financial statements they write that capital expenditures for the Volvo Group is 14,034. Seems like it is the capex including both the fixed assets and the leasing, or? In the consolidated cash flow statement they say "Investment in fixed assets" is 9,969 and "Investments in leasing assets" is 4,611. I don't really get this.

What should be included when calculating capital expenditures?

I would be very happy if someone could help me and write some words about this. What do you think Joe?

Thanks for a great blog!

/E
Alan' gravatar

Alan
Jun 23rd, 2008
2 comments

Hi there,

Great use of the Morningstar data. Do you know of an equivalent in the UK as Morningstar's UK site has less data for free (you have to be a premium subscriber to get what the US site gets.)

Thanks.

I don't know of one. Anyone have some thoughts?
Alan' gravatar

Alan
Jun 24th, 2008
2 comments

I've found this link:

http://ogres-crypt.com/ph...


"per=" can either specify "q" (quarterly) or "a" (annual)
"get=" specifies how many periods to get
"wb=" can either specify "y" (open in workbook) or "n" (open in browser)
"sym=" specifies the ticker symbol


Thoughts?
Jeff' gravatar

Jeff
Jun 24th, 2008
4 comments

ALan,

Unbelievable link.

Any clue where it's pulling that data from??
Jae Jun' gravatar

Jae Jun
Jun 29th, 2008
12 comments

Don't exactly know where that data is from but the guys at SMF Yahoo Groups use it to run their automated functions.
Andrew' gravatar

Andrew
Feb 22nd, 2009
4 comments

Joe,

Why doesn't Buffett's calculation of owner earnings subtract principal payments on debt?

On one hand, I think they should be subtracted because they are cash flows that are not available to owners, but to creditors.

On the other hand, as you reduce the "net debt" portion of enterprise value, you inherently increase the equity value.

How do you look at this? Thanks.
The "value" of the enterprise is in the cash that can be taken out of it. When a company generates excess cash, it can pay off debt, buy back shares, acquire assets, hire sales staff, etc. — all of which can serve to increase the future value of the business. Or, it can pay that cash out to owners as dividends.

When you buy a business as an ongoing concern, you are buying that future cash flow. You hope that management has enough sense to increase the value of the business or, in the absense of the ability to do so, to pay the cash out as dividends.

How management uses that cash (e.g., to pay off debt) does not affect the value of that cash flow; so, it is not subtracted from owner earnings — the amount of cash the business can generate regardless of how management employs that cash.

Make sense?
Andrew' gravatar

Andrew
Feb 26th, 2009
4 comments

Free Cash Flow to Equity (FCFE) is after debt principal payments (or net borrowings), because the logic goes, debt payments are FCF to debt holders, not equity holders. That's why Free Cash Flow to the Firm (FCFF) is cash available to the firm , ie. before debt payments, and FCFE is after.

Buffett's "owner earnings" is very much like FCFE; both are meant to be free cash flow available for shareholders. However, like I said, the defintions differ in that FCFE is after debt payments, while owner earnings is not.

The "value" of the enterprise is the cash you can take out of it, like you said. So then after discounting those cash flows you have an EV, from which you subtract net debt, to find the equity value. But discounting FCFE, which is after debt payments, is meant to find equity value directly.

Yet, Buffett's owner earnings is net income d&a and non-cash items - maintenance capex. If a company has required debt payments for the next 5 years that is the entirety of that owner earnings, how is that cash owners can take out of the business? Literally, it's not. But my question is, does Buffett ignore that because paying down debt principal, while not literally available to be given to shareholders, inherently increases the equity value portion of the EV. For example, if a business is worth X, with a capital structure of half debt, half equity, and you pay down debt..... assuming the business is still worth X, you have a capital structure of less than half debt, MORE than half equity---- so it does benefit shareholders, although somewhat indirectly.
Amit' gravatar

Amit
Mar 1st, 2009

Andrew, that's a GREAT question.
Interest on required debt payments are factored in to net income, and naturally serve to reduce owner earnings. Additional payments on debt above and beyond the minimum required are made with cash that can be (i) used to pay off debt, or (ii) paid out to owners if management chooses to make the minimum payment.

I originally misunderstood your question. The "principal" portion of a debt payment increases the value of the company because it reduces overall debt and serves to reduce future cash flow burdens. Theoretically, management could refinance any such principal interest loan into, say, a bond with no principal payments for some time. Assuming you are valuing the business as an ongoing concern, the business could theoretically delay those principal payments indefinitely by refinancing periodically in the future.

As such, the owner earnings used to pay down debt would be able to be withdrawn from the business.

The point is this: The owner earnings tell us what the business can produce. How management uses this year's cash to increase the future value (paying off debt or refinancing it ad nauseum to pay out dividends) doesn't change the amount of cash produced by the business' operations this year. We hope to find managements intelligent enough to use that cash wisely.

Does that make sense?
Andrew' gravatar

Andrew
Mar 4th, 2009

Yes, it makes sense. Therefore the textbook FCFE understates free cash flow as owner earnings defines it.

But how about this scenario:

A highly leveraged company...
owner earnings of 83 mm
Market cap of 300 mm
Net debt of 822 mm
EV of 1,122 mm

Do you consider the free cash flow yield to be 7.4% or 27.7%?

In this case, the yield would be 27.7%. That said, the question is: Can this business survive long enough to pay down the debt? With every dollar of debt it pays down (assuming everything else stays the same), future cash flow increases.

Let's say the business' debts are at 6%. Today's interest payment is $49.3 million. (That was already accounted for in owner earnings.) It has $83 million to pay down debt. Let's say that it uses 70% of its excess cash flow to pay down debt each year.

Twelve years from now, the company is debt-free and generating $129 million in owner earnings. The markets are acting rationally, and this business is selling for, say, ten times cash flow — or, $1.2 billion.

Your return would be about 12%. Paltry, you say, because you want higher returns. Well...the price will not likely tick up 12% a year; rather, when the fear surrounding this company subsides, it will likely explode up to a more rational price over the course of a year or two, and then begin to tick up from there.

What is a rational price? If we stick with the "ten times cash flow" theme, this business should be an $800 million company today. If it takes four years for the company to prove that it can handle its debt and manage through this crisis, it would (at the above valuation metric) be a $900 million or so business. With the fear surrounding the company beginning to subside, Mr. Market will begin pushing the business higher — to a more rational level.

Over the course of four years, an investor in this scenario would earn about 32% a year (regardless of where the price went tomorrow or next year).

All of this, of course, goes back to the original question: Can this business navigate the storm and emerge stronger? The numbers are the easy part.

Does that make sense?
Ajay' gravatar

Ajay
Apr 7th, 2009
6 comments

Hi Joe

I am new to investing and thought of getting some knowledge before bumping head on with Mr. Market.

I have a question regarding FCF and owner earnings according to you:

Free Cash Flow=Net Cash From Operations - Capital Expenditures

Owner Earnings = Net Income Non-Cash Charges (Depreciation, etc.) - Capital Expenditures

Looking at JNJ 2006:

FCF will be : 14248 - 2666 = 11582
OE: 11053 2177 - 2666 = 10564

Why than you have taken OE as FCF here. I am missing a point here ?
Also how did you arrive at a return of 12% and 32% in Andrew's hypothetical example ?

Thanks in Advance and hats off to you for this wonderful blog.

Regards

Ajay
Andrew' gravatar

Andrew
Apr 11th, 2009
4 comments

Buffett does not take out required principal payments on debt to get to owner earnings. I understand that and understand why- because regardless of capital structure, over time, this is cash that one way or another (dividends, stock buybacks, reinvestments, or debt paydown) is beneficial to the equity holder.

Then why doesn't he also add back interest expense, after tax, to owner earnings? While on the accounting cash flow statement, this is considered an operating cash flow, it's really a financing cash flow. It's an expense that would not be required of a company with an all-equity capitalization.

My issue is: FCFF is before all payments to debt holders (interest and principal), and FCFE is after all payments to debt holders (interest and principal). Buffett does not appear to be consistent with his treatment of one financing cash flow (interest) and another financing cash flow (principal payments). How do you reconcile this?

Thanks.
Andrew' gravatar

Andrew
Apr 11th, 2009
4 comments

Put more concisely- interest and debt payments are both a function of capital structure; not of the cash generating power a business. I don't understand why he doesn't add back in after-tax interest expense, since it's deducted from reported earnings.
Let's say a company issues $1 million in debt with a 5% coupon. The company will have to pay $50,000 a year in interest on that debt which, as you pointed out, reduces earnings. Now, why would the company issue that debt unless it believes that it could generate more than $50,000 a year in cash flow?

Assuming the company uses that debt to effectively increase pre-debt-payment earnings by $80,000 a year, the net effect of that borrowing would be an increase in earnings of $30,000 ($80,000 income minus $50,000 in debt payments).

You can't add the $50,000 back in to the mix because without that borrowing and debt payment, the extra $30,000 of profit wouldn't exist.

Though the debt (and thus, interest payments) are a function of the capital structure, they play an integral role in the earnings power of the business. A company doesn't have to be debt free so long as it is intelligently employing that debt. But, we shouldn't ignore the cost of that debt or its effect on earnings, both because it exists and if it didn't.

Make sense?
Edward Allen' gravatar

Edward Allen
Apr 29th, 2009
1 comment

Hi Joe
If we are trying to get at the core free cash a business generates, it struck me that we need to also take account of the cash that the business sucks up in inventory and WIP each years. After all it's likely that a steadily growing business will require a similar steadily growing amount of cash isn't it??

So would you recommend that the equation is:

Reported Earnings Depreciation - Capital Expenditures -changes in working capital

where Change in working capital is the change in STA less STL each year

Or am I double counting something here?!

what got me started on this was looking for the possible uses of OE in a business after dividends & buy backs, and it lead me to this. Can you think of any other core ways a business can utilise the proportion of OE that it actually retains?



many thanks
Joie' gravatar

Joie
Jul 19th, 2009
3 comments

Hi Joe, thank you again for sharing your knowledge to the world. I find myself plowing through your every posts in the blog. I am very fortunate to find this site to learn.

I have read 5 year annual report of 4 companies in the food industries in my country
No apparent preference, just picked some random industry where the products are well known in the market.

Either using owner earning or free cash flow, the hardest part is to estimate the capital expenditure.
How do you do it ? Do you just look for "purchase of fixed assets" in the Investing part of the cash flow statement ? Or do you look for balance sheet changes between the year in the fixed assets ?

If the cap ex for a year has been found, does it have to be averaged out for 5 year to compute the owner earning and free cash flow ?

Regards,
Joie
Dustin Noe' gravatar

Dustin Noe
Oct 10th, 2009
1 comment

What about owner earnings per share? It would factor in share buy backs and dilution. Would it be smart to use this in place of owner earnings or am I thinking wrong?
Stephen Kutney' gravatar

Stephen Kutney
Nov 18th, 2009
6 comments

Should Inventories be subtracted in the calculation of Owner Earnings?

I have this paper from Joe called Owner Earnings vs. Free Cash Flow. I see the inventories subtraction on page 13 but I don't see it mentioned in the text of the paper or the book as something that should be subtracted.

Steve

Eric T' gravatar

Eric T
Jan 2nd, 2010

Joe,

I noticed you kept out additional working capital needs in your buffet quote. I have read that buffet subtracts the additional working capital needs (if any) from one year to the next in his owner earnings calculation. I suppose this is to help account for principal payments on long term debt that are coming due. Why don't you include this in your calculation?

Thank you

-Eric T.

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