This article is via a now-defunct website written by a young man who was just getting into finance. I consider it the best analysis of Warren Buffett’s 1986 Letter to Shareholders wherein he defined “Owner Earnings” I have ever seen. This is how I understand and calculate Owner Earnings for my own stock selection.
I am posting the entire article below. I claim no copyright.
First, you will want to download the pdf which you can by clicking on the link here:
The pdf from the link above includes the Appendix to Buffet’s 1986 Shareholder Letter in which he defines Owner Earnings. Keep this attachment open as you read the analysis below.
Buffet’s 1986 Letter to Shareholders – Owner Earnings Demystified
As I have mentioned before, Buffett did us all a huge favor by explaining, in depth, one of the key measurements that he uses in his valuation process, in his 1986’s Letter to Shareholders that comes annually together with Berkshire Hathaway’s financial reports.
For years I have read dozens of different interpretations to what’s written there, and now I would like to take the time to explain, in plain English, what I consider to be one of the cornerstones of valuation: Owner Earnings.
In order to understand Owner Earnings (or simply, OE) we must delve, deep into Buffett’s explanation. It may seem like a lot, but if you want to understand it fully, that’s the only way to go.
If you haven’t before, grab yourself a cup of coffee and put some John Mayer songs to relax yourself and get ready for some in depth analysis. This is going to be a long one.
In the beginning of the note, Buffett gives us two seemingly different income statements, and later informs us that they both belong to the same company, Scott Fetzer, one before it was bought by Berkshire (Company O) and the other the day after (Company N).
He emphasizes four different key figures, which ultimately make Company N’s show considerably smaller income. Those figures are:
A Special non-cash inventory cost of $4.979mil.
An increase in Depreciation of $5.054mil.
A $595k Amortization cost.
A non-cash inter-period allocation adjustment of $998k.
First of all, you should understand why any difference exists at all. When a company buys another company, it often pays more for the company than it’s reported ‘net worth’, meaning the sum of assets minus the sum of liabilities, or book value. The reason for this is that companies pay for intangible assets that are often not listed on the balance sheet, such as a brand name, patents, etc. As well as pay for appreciation in tangible assets that is also not listed on the balance sheet.
Following the transaction, the premium paid has to be displayed on the acquired company’s balance sheet. So, in Scott Fetzer’s case, Berkshire paid a premium of $142.6mil, that now has to be listed on the balance sheet. You can treat this as some sort of update of the company’s balance sheet to current value.
So, going one by one, I’ll explain the accounting in each of the figures:
A Special non-cash inventory cost of $4.979mil:
Starting with adjusting the value of the current assets, the accounting practice is to check whether or not any of them are carried at less than current value. Because items like receivables and cash (DA. -_-) are always carried at current value, the big change comes in inventory, where an inventory that was acquired just one year ago can change dramatically in value, a change that is not presented on the balance sheet (think of last year’s computers, phones, cars).
Unless you had some training in accounting, the next part may seem complicated, so feel free to go straight to figure number 2 if needed.
Buffett allocated $37.3mil of the $142.6mil premium to increasing inventory because of an existing LIFO reserve. A LIFO reserve is the difference in the value of the inventory between FIFO accounting and LIFO accounting:
LIFO Reserve = FIFO Valuation – LIFO Valuation
So basically, Buffett adjusted the value of the inventory to the higher end of the valuation spectrum. The effect on the income statement is a little bit different – Because the income statement measures only costs that affect the same year, of the inventory increase in the balance sheet, only $4.979mil is applicable to that fiscal year.
An increase in Depreciation of $5.054mil:
Next move: Adjust fixed assets. Fixed assets are increased by $68.0mil (update to current value, as measured by the acquisition price), and that sum is depreciated in a way to reflect the real use of assets.
Another $13.0mil is deducted from deferred taxes as a tax shield – Explained later.
A $595k Amortization cost:
After all the other costs are made, the residual $24.3mil is amortized over the normal 40 years period. Which comes out at a regular cost of $607.5k, and slightly less for the mentioned year, because Scott Fetzer was acquired on January 6, resulting in a slightly lower cost for this fiscal year.
Amortization is basically depreciation for purchased companies.
A non-cash inter-period allocation adjustment of $998k:
I know Buffett lists this as too complicated, but sue me, I love complicated stuff. Again, feel free to skip it.
When an asset is purchased, the company lists a ‘tax shield’, so it won’t have to pay taxes in a case where it sells the asset in the future. The same thing happens in the case of an acquisition, because a tax shield is created on the premium the acquirer paid for the acquired assets.
Of the $13.0mil change in the balance sheet, $998k is accounted for the fiscal year (and twelve similar charges will follow in the upcoming years).
A problem, is it?
So, a problem arises. How can a company have considerably less income just because it was acquired, where there’s no economic difference? And even more, how do we overcome this?
Buffett suggests Owner Earnings as the solution. The idea is to replace the Net Income with a figure that will be more guarded from non-economic changes.
Owner Earnings = Net Income plus Depreciation, Depletion, Amortization and Certain other non-cash charges such as Company N’s items (1) and (4) minus the average annual amount of capitalized expenditures for plant and equipment that the business requires to fully maintain its long-term competitive position and its unit volume.
Let’s go one by one:
Net income – Straight from the income statement.
Depreciation, Depletion and Amortization – This change is critical, because 95% of accounting fallacies happen with the DD&A aid.
Certain other non-cash charges, such as Company N’s items (1) and (4) – I don’t think one can determine some sort of specific rule that would suit 100% of the companies in this case, but if you must, take this as a general statement: Any permanent non-cash charge made to inventory valuation or allocation adjustments relating to tax purposes, in the case of an accounting change, such as in the case of an acquisition, is to be counted in the OE formula.
Capital Expenditures – When looking at this line, one should remember that Buffett wrote these lines before the cash flow statement was mandated in 1987. Back then he estimated the CapEx figure using the average depreciation and amortization figure as a base point, as those usually account for the company’s annual spending on manufacturing fixed assets, and mentioned that in the Scott Fetzer case, the “old” accounting gives a better estimate.
Some people think that you should estimate the maintenance CapEx and the Growth CapEx components differently, using a formula made by Prof. Greenwald of the Columbia MBA program. I think it’s a good concept (although not perfect), and in order to stay on the subject I will not go into details.
One more careful observation should be made on Buffett’s note on ‘additional working capital’. Some people take that for ‘always add changes in working capital, and so they take Free Cash Flow as a perfect substitute for Owner Earnings. I do not agree. If any permanent changes do occur, add them, but it is pretentious to think that all changes in working capital fall within this definition.
Told you it will be a long run.
So there you go, Buffett’s note explained in depth. I just wish there was someone to help me with all the confusion I had with it back when I started.
 Think of land – It is always listed at cost, but usually increase significantly in value over time.