34. Warren Bufett's Owner's Earnings Calculation Video Lecture | Become an Expert: Value Investing - Business Basics

welcome to course three unit seven
lesson seven
what is owners earnings up into this
point in the website we've talked about
net income and then whenever we divide
up the net income by the number of
shares a company has we call that
earnings per share or the EPS in this
lesson we're going to talk about
something a little bit different and
it's something that Warren Buffett calls
owners earnings okay so starting from
the very beginning we know that the
income statement is where we figure out
what the EPS is or the the net income of
the business and so when we turn to that
income statement and we look at the very
bottom line that's where the net income
is at and this is the profit of the
company if we want to figure out what
that profit is per share what we do is
we just take that net income and we
divide it by the number of shares
outstanding and that tells us the EPS
where the earnings per share um you also
know from previous lessons that that EPS
is then paid to you as a shareholder is
the owner of that business two different
ways it's paid to you directly through a
dividend which would be the top method
and for this example we are just gonna
use an EPS of two dollars and we're
gonna assume that $1 pay view directly
straight as the owner through a dividend
and then the other dollar is reinvested
back into the business okay and so what
we're going to be talking about whenever
we talk about owners earnings is we're
really gonna focus on that bottom number
where that one dollar is being
reinvested back into the business okay
so I've got a very generic scenario here
we're just going to use the same two
dollars of EPS that we were just talking
about before okay and let's assume that
we're looking at a business that has a
book value of $20 so as we start over on
the far left of this slide you can see
that the previous book value prior to
2009 was $20 and if we had a business in
a very generic scenario here that had a
$2 earns per share we're gonna assume
that $1 that earnings was paid to the
owner as a dividend and that the other
dollar was reinvested back into the
company and what it did is it made the
book value grow by $1 so
we see the book value change from 20 to
21 dollars in 2009 the same exact
scenario occurs in 2010 and we see the
book value raised the twenty two dollars
and one dollar of a dividend was paid
and then in 2011 the exact same thing
which made the book value raised $23 so
in that scenario what was the earnings
per share what was the EPS and then also
I want to know what was the owners
earnings okay so for that scenario we
when we look at the accounting okay when
we're we're talking about the accounting
we're talking about the earnings per
share that number that's reported at the
bottom of the income statement which is
two dollars whenever we talk about
owners earnings we also in that scenario
through analysis we saw that the owners
earnings was also two dollars the reason
that the owners earnings was two dollars
is because we earned $1 in the dividend
and we actually saw the $1 that was
being reinvested into the company
actually materialized in the book value
okay so in that scenario we had the the
actual accounting earnings that were
being reported equal they'd be exactly
the same as the owners earnings so what
we're gonna do next is we're gonna make
the scenario more realistic so that last
scenario isn't very realistic but the
next one is gonna be more realistic and
that the money that's being reinvested
back into the company might not actually
turn into owners earnings and so let me
demonstrate that for you okay so we have
the exact same company the book value
prior to 2009 we're gonna say is $20 and
that the earnings the EPS for 2009
according to the accounting that number
that was reported at the bottom of the
income statement is $2 okay we're gonna
assume that still $1 is being paid into
the dip or being paid to you as an owner
through the dividend okay but this time
you only saw 50 cents of book value
growth and the book value increased up
to 20 dollars and 50 cents okay in 2010
we saw the exact same thing not the
whole dollar was materializing into our
book value in same thing in 2011
instead of seeing the book value at the
end of 2011 up at $23 the book value
this time is only 21 dollars and 50
cents
so this disparity that we're talking
about is the difference between reported
earnings which is coming from accounting
and owners earnings which is slightly
different so let me show you what this
looks like so in that scenario we had
the accounting earnings was $2 and the
owners earnings which is how Buffett
would describe it was only one dollar
and fifty cents per year okay so where
did that 50 Cent's of earnings per share
go because that's your money as the
owner of the business that 50 Cent's
which never materialized that's your
money but where did it go why didn't you
why did you see all that materialize so
whenever we look at the two directions
that that EPS can go that accounting EPS
that's at the bottom of the income
statement we know that it can be paid to
different directions we know that it can
go to the owner and when that happens
when that's paid as a dividend that
materializes as owners earnings
immediately okay we know that that's
part of the owners earnings now whenever
we look at the dollar that was invested
down in the business this may or may not
turn into owners earnings okay and
that's what we're gonna discuss here on
this next slide is we're gonna focus in
there on that dollar that's going
towards the business so when we look at
this you can see the EPS of $2 we invest
$1 back into the business okay and we're
gonna look at just two paths that that
dollar could be invested it's obviously
a whole lot more than this but in order
to make this kind of make sense we're
just going to do two paths so on one
path over on the left you can see that
50 Cent's was used to invest in another
stock okay so just imagine a company
okay it has the ability to take their
earnings and actually invest that money
into yet another company okay and when
they do that that company is gonna
continue to pay them earnings when a
business would do something like this
that 50 Cent's will just say that they
use 50 Cent's to invest in another stock
pick that's going to show up on their
balance sheet is another asset and so
that would materialize into extra
book value during the next accounting
period now the other 50 cents as we look
to the right there at the bottom right
that 50 cents was used to invest back
into the company but it was invested in
in a manner that replaced the computer
will say replace the computer that they
already possessed okay so that computer
imagine the old computer being on the
balance sheet listed as an asset that
computer was then replaced with a new
computer that they bought with this with
this 50 cents of this share and so the
new computer replaces the old computer
on the balance sheet and that didn't add
any money on to the balance sheet it
didn't add any more money on to that
book value okay so as far as we're
concerned that it's almost like that
money disappeared as we look at the
earnings per share and how they
materialize into more book value growth
so same same concept but I have a
color-coded here you can see how the the
dollar that was paid to the owner as a
dividend is Kareem so that's our owners
earnings when we go down to the dollar
that was invested in the business only
half of it turned into owners earnings
that money that was invested in the
stock pic that was additionally added on
to our balance sheet okay where the
$0.50 it was invested in the new
computer the whole computer was taken
off the balance sheet and discarded and
the new one was purchased and put in its
place
and we didn't see any book value growth
based off of that so this is our
difference when you see those two green
that's that's the owners earnings that's
what Warren Buffett's is that's what
he's referring to whenever he says
owners earnings the 50 Cent's that comes
off you could maybe call that the
company's earnings because that's not
something that you actually saw
materialized so now that you understand
the basic concept of what owners
earnings actually represents and what
that terminology means let's go ahead
and try to do this for a real business
and we're gonna use Walmart in order to
exemplify this
okay so here's Warren Buffett's quote on
owners earnings and this quote was
pulled from his shareholder letters from
1986 and I'm gonna read this for you so
Warren Buffett says owners earnings are
reported earnings Plus that the
the pollution amortization and the
certain other non-cash charges to
include or exclude deferred taxes unless
the average annual amount of capitalized
expenditures for plant and equipment and
etc whatever else might fall under that
category that the business requires a
fully maintained its long term
competitive position in its unit volume
so I'm sure for a lot of people that
just sounded like Charlie Brown's
teacher so what I'm gonna try to do is
really break that down and make sense of
that quote for you okay so don't get
intimidated with this slide all this is
is the cash flow statement for a Walmart
so I'm sure if you've looked at the
videos prior to this one you've seen me
pull up a cash flow statement before if
you're using ms/ms n money you're just
gonna go down to the bottom left hand
side and you'll see a tab that says cash
flow and you're gonna click on that for
Walmart and what'll come up is what you
see here on the slide okay now that
quote that you saw on the previous slide
from Warren Buffett he described what
owners earnings was and so what I've
done is I've broken it down into kind of
an equation there for you on the right
hand side so as we focus in there on the
right hand side you can see it says
owners earnings equal net income plus
depreciation plus amortization and all
those different categories - the capital
expenditures okay and that the fir'd
taxes can kind of go either way
depending on how its listed so as we
look at all those items right there one
of the advantages that we have today
that Buffett didn't have back in 1986 is
the cash flow statement
back whenever he was whenever he wrote
that piece that we pulled the quote from
there was only an income statement and a
balance sheet so he didn't have the
luxury of kind of viewing a cash flow
statement but for us it's a whole lot
easier because all these all these
numbers are listed right on the cash
flow statement so as we look over there
to the cash flow statement what I want
to do is I want to highlight where each
one of those terms are at from the
left-hand side on the cash flow
statement to the right hand side where
I've kind of laid out the basic equation
so the first thing I'm gonna highlight
is the net income you can see where it's
out on the cash flow statement because
it's highlighted in green okay now when
you look at the depression
d--ation you can see it's on the next
line down and it's also highlighted in
green now then the amortization that's
highlighted in green and for Walmart
they don't have anything listed on their
cash flow statement so it's going to be
zero
okay our deferred taxes now this one's a
little bit trickier and you can see I
highlighted this one in yellow and the
reason I highlighted in yellow is
because sometimes it's positive like in
2012 and 2011 and then when you look in
2010 it's actually a negative number and
then you have the non-cash items and you
also have changes in working in capital
and so I'm gonna highlight both of those
in green and you can see that the
changes in working capital can also be a
plus and a minus just kind of like our
deferred taxes but all those items are
listed right there and they're all
summed up which is just great we don't
even have to do the math for that all
those are summed up right there under
the cash from operating activities which
I now have highlighted in green okay so
that's really the overall all those
things that are listed there I'll turn
into that one line at the bottom there
where it says cash from operating
activities that's the thing we want to
focus on okay now the thing we have to
subtract out is the capital expenditures
okay now capital expenditures are those
things that are that we're spending
money on as a business in order to
sustain our operations so if we were
gonna go purchase stock and it's a new
asset that's gonna create a new stream
of income that's not going to be listed
under capital expenditures only things
that we're currently using in order to
produce current income streams is what's
listed under capital expenditures so
that's why we're going to be subtracting
all of that out from that operating
activity cash that we have right above
it okay so to simplify that equation we
can see that I have everything kind of
fogged out there and you can see that
the two numbers that really mean a lot
is that cash from operating activities
and then the capital expenditures and
what we're going to do is we're just
going to take the difference of those to
come up with the real owners earnings
opposed to the EPS that's being reported
on all those top-level pages and things
like that so let's compare Walmart's
accounting earnings that's being
reported at the bottom of the income
statement for
says that owners earnings that we just
showed you the little formula for okay
so I've kind of fogged out all the
numbers here and I'm just showing the
numbers that you need to in order to
account for these things so the first
thing that we're going to do is we're
just going to calculate the number at
the bottom of the income statement from
the cash flow statement okay and in
order to do that we're just gonna look
at the very top number which is our net
income and that comes straight off our
income statement okay that's that bottom
line number at the bottom of the income
statement so that number you can see is
listed and then I have the number of
shares diluted which I pulled off of the
income statement listed underneath of
that and to in order to find our EPS
diluted all we're going to do is we're
going to take the net income and divide
it by the number of shares outstanding
which is our that's we're going to use
the diluted number because we're that's
going to give us a more accurate number
when we divide those two that gives us
our EPS diluted and this is the number
that's the accounting number this isn't
the owners earnings we're going to do
that next okay so as we go through this
for Walmart you can see 2012 we had four
point seven one all the way through 2008
where it was with down at three point
two three okay so all of that you should
have already known from all the previous
lessons now what you haven't done yet is
the owners earnings so in order to do
this we go to the cash flow statement
and you can see I have the top number
there is the cash from operating
activities and I highlighted that in
yellow right there for you to see and
then right underneath you can see we
have the capital expenditures which is
now highlighted in yellow and what we're
gonna do is we're just going to take
those two numbers and we're gonna find
the difference between them okay now I
see you can see that the capital
expenditures are already listed as a
negative number so I guess you could
technically say we're gonna add them
together but all you're doing is you're
finding the difference between those two
numbers if they weren't listed as
negatives on this particular sheet so
when we do that we come up with ten
thousand seven hundred and forty five
for year 2012 all the way through 2008
where it's five thousand seven hundred
and five now those numbers are obviously
billions because we've dropped all the
zeros off of them but uh that's going to
give you your that difference right
there is your owners or
okay and in order to figure it out per
share we're just gonna divide that that
difference by the number of shares
diluted and then at the bottom you can
see we have the owners earnings diluted
which for 2012 it was three dollars and
nine cents and down the two thousand
eight whereas one dollar and forty cents
okay so let's let's put these two
numbers right next to each other let's
look at the EPS that was the accounting
number and then let's look at the owners
earnings EPS and see what we came up
with okay so here's that right now at
the top we have the accounting earnings
and underneath event we have the owners
earnings that we just calculated okay
now instead of looking at the number of
the difference in the number there I
made a little chart so it's more visual
for you to see the difference between
the two so when you look at the chart
and you see the blue in the chart that's
the owners earnings when you see the red
that's the accounting earnings that you
see so when you look at that comparison
you can see how much higher the
accounting earnings are saying that the
numbers are versus what's actually being
materialized for the owner if you were
the shareholder of this you would see
that the number in the blue that's what
you would actually be seeing come into
your pocket opposed to what's being
reported on the accounting income
statement which is the red so that's a
pretty significant difference when you
look at that and this is why Buffett
places so much value in this this
calculation and understanding what
owners earnings is because he knows as a
shareholder that's what he's actually
gonna see opposed to what's being
reported so let's make this really fun
okay on the top we have the accounting
earnings and then we have the owners
earnings underneath of that now what I'm
gonna do is I'm gonna show you what
actually materialized during that period
from 2008 to 2012 and in order to do
that I listed the dividend which you can
see right there have an arrow next to it
you can see the dividend during that
time period and then you can see the
change in the book value during that
period and all I did is I added up those
two numbers okay and then you can see I
totaled them for each year so for like
2012 the total for the shareholder was
$2 and 83
it's because they had $1 and 37 cents in
the book and they had $1 and 46 paid to
them and a dividend and so what I did is
I added up all of the those dollars that
you would have received as a shareholder
if you owned Walmart from 2008 to 2012
you would have received $11 and 54 cents
either indirectly paid into the book or
paid directly to you for owning those
shares and that money was paid to you as
a dividend so what I find really
interesting here is look at the very top
number where we had the accounting
earnings if we were going straight off
that EPS we would assume that we'd be
paid $19.90 if we would have owned
Walmart if we would have owned one share
of Walmart throughout that time frame
then as we take a step down and we look
at the owners earnings which we
calculated off the cash flow statement
we'd have a much lower number and that
we would have only received 14 dollars
and five cents because a lot of that
money would have been paid to sustain
operations because when you think about
Walmart they've got an enormous
inventory they've got the enormous
number of buildings all those things
require a lot of capital and it's a lot
of capital that's going to be reinvested
back into the business just to sustain
operations not to grow okay so that's
why you're seeing that a decrease but
what you actually saw materialized as
the shareholder is what's down at the
bottom and that's the dividend and the
growth in the book and that was only $11
and 54 cents okay so this is pretty
interesting to look at these three
different lines here and see what the
owner actually received versus what you
would have calculated versus what was
being reported so as we look at this and
we understand Buffett's opinion on
goodwill and a couple other things we
can see why Buffett likes to minimize
his net tangible assets and this is the
reason why tangible assets will most
likely need replaced or maintained it's
like that computer it's like all the
inventory it's like the buildings for
Walmart all those things need maintained
all those things need to be replaced and
what this means is a decreased amount of
owners earnings so what's the point of
all this is what you're probably
okay why are you telling me this now and
what should I take away from this how
can I use this to my advantage
so I have a lot of points here and I'm
gonna try to go through these as quickly
as possible there's a lot of people on
the internet that treat buffets
description of owners earnings like it's
the holy grail of value investing and to
a certain extent it kind of is because
you you're actually calculating what
you're gonna receive opposed to what's
being reported I think that owners
earnings is very important to understand
but as far as understanding his
calculation and getting into the
intricacies of that short term look I'm
not convinced of that
I believe that understanding the concept
of owners earning is more important so
if you understand what owners earnings
about that's what's important not
necessarily maybe doing that particular
calculation because as you saw on the
last slide or the last two slides what
we calculated was actually a little bit
different than what we actually saw
materialize from the dividends in the
book value group I think the bottom
one's more important okay remember the
actual owners earnings is two things
it's that book value growth and it's the
dividends that's what owners earnings
really is okay so in order to understand
why maybe a lot of people on the
internet are placing so much value in
his calculation is because they're kind
of ignoring the context of what his
shareholder letter was written back in
1986
whenever Buffett wrote this the reason
he was explaining his opinion on how to
calculate owners earnings was because he
was conducting a 100% buyout of a
company called Scott Fetzer's and when
he was doing that he was paying almost a
hundred percent premium over those net
tangible assets that the company was
listed for on their accounting for their
income statement and for their balance
sheet so in order to buy this company he
had to prove his valuation with
accounting terms and cap rates whenever
he came up with what he thought that the
book value on the company was and how
much their earnings were then he had to
take a capitalization rate on top of
that and when he's doing this he had to
explain to his share
in 1986 why he was paying such an
enormous premium for this company and so
this was really the reason for his
detailed explanation he had to explain
the accounting gymnastics that took
place as he conducted that acquisition
of that business so I think that
whenever people take a step back and
they look at the context of why Buffett
was explaining that really in-depth
owners earnings calculation it was more
in an effort to show his shareholders
why he had bought that company and this
was during an entire 100 percent
acquisition of another business so
here's my recommendation okay
understanding that calculation is great
you have to fully understand the
difference though between owners
earnings and accountings earnings from a
general standpoint what I was talking
about at the very beginning of this
briefing is what you have to understand
you have to understand that all that EPS
isn't going to necessarily materialize
into actual earnings into your pocket so
that's my first recommendation is that
you truly understand the difference
between accounting earnings and owners
earnings that's what I think is
important just understanding that
difference the second thing that I'll
tell you is to continue valuing your
companies based off of the book value
growth and the dividends because
ultimately at the end of the day if that
company invests all the money that's
being put back into the company well
you're not gonna see the book value grow
so you're gonna immediately see that
trend especially if you're buying a
stable company which is mandatory for
all of this if you're buying a nice
stable company and you're not seeing
their book value grow well that tells
you immediately that the only money
that's actually going to turn into
owners earnings is your dividend so I
think that you're gonna be well off by
just sticking to your estimates of how
much is the book value growing how much
are they paying a dividend how much is
reasonable into the future okay the
third thing when you're assessing the
future earnings of a business ensure
that your estimate is gonna remain
stable or increasing from what has
happened in the past so after we're done
with the the fourth point I'm gonna show
you exactly what I mean by going to MSN
Money and pulling up Walmart and I'm
going to show you what that tenant that
third recommendation is talking about
and then the fourth recommendation I
think that if you're buying a company
you need to check that cash flow
statement quarterly when those earnings
reported to ensure that the ratio
between that operating activities and
your capital expenditures remains intact
so for Walmart we have a real good idea
if you remember that that graph that I
showed you when we looked at that ratio
between what was being reported and what
was actually occurring we have a pretty
good idea of how Walmart operates and
how much capital expenditures they need
to use in order to maintain their
business and also grow so when you look
at that you need to make sure that that
ratio between those two numbers is
remaining intact and I'm also going to
show you that right now so let's go
ahead and do the the third
recommendation and then I'll show you
the fourth recommendation so here I am
in MSN Money and in order to pull up
Walmart we're just going to type WMT and
hit enter okay and you can see here's
Walmart and the first thing that I said
in in the third recommendation was that
you have to look at the company's future
earnings okay so in order to get a brief
idea of what their past earnings are
let's go ahead and pull up their
earnings over the last ten years so in
order to do that I clicked here on the
ten-year summary and you can see this is
Walmart's earnings per share over the
last ten years so it went from 176 to
2:246
clear up to an EPS of $4 and 54 cents
here in 2012 okay so we can see that
growth that trend in that earnings per
share over the last ten years so let's
look at what the earnings are going to
be in the future so in order to do that
we come over to the left-hand side here
right where my mouse is at and we're
going to go ahead and click on the tab
titled earnings okay so when we look at
the estimates for fiscal year 2013 we
can see that the earnings are four
dollars and ninety cents okay
that's higher than what they are in 2012
then when we look at the earnings the
projections for 2014 the projections are
five dollars and 30s and 36 cents now
that
among the number of analysts that are
predicting this r22 for 2013 and 24 2014
now what are the chances of those
earnings actually coming into fruition
probably slim to none that those numbers
are actually going to turn out like that
but I would much rather see a forecast
that's projecting positive earnings than
something that's negative so this is a
great sign and this is exactly what
we're looking for as we look to the
future and what the earnings might look
like so the next the last recommendation
that forth recommendation was that now
now that you see that the earnings are
projected to continue to increase into
the future now I think what you need to
do is you need to go down and look at
the cash flow statement
okay so let's click on the cash flow
statement right here okay and we're
gonna pull up we look at right here from
the annual what you're going to continue
to do into the future is these does
these cash flows continue to develop and
you're probably don't want to pull up
the interim for each quarter okay so
you'd click right here on your interim
and you would continue to assess this
line right here the cash from operating
activities and you'd compare that to the
capital expenditures you're gonna
constantly be comparing that ratio
between those two to make sure that it
stays in check now I'm gonna caveat this
that ratio between those two is you know
for when you get into a more volatile
company Walmart's pretty stable when you
get into a little bit of a more volatile
company that ratio is gonna constantly
be changing up and down and kind of all
over the place but the the long-term
trend is what you're really looking for
you want to make sure that it's not
continuing to decrease you want to make
sure that it's staying level or maybe
even becoming more favorable so there's
a little bit of a demonstration on how
you can implement the two
recommendations that I have for you
recommendation three and four off of the
final notes that I had for this lesson
so this concludes course three unit
seven lesson seven what is owners
earnings
[Music]