You will not be surprised to learn, that one of the most insightful investment concepts I learned early on my investing journey was about understanding a company’s earnings came from Warren Buffett.
In his 1986 Chairman’s letter to shareholders, he provided instructions to determine the true underlying earnings a business owner would actually receive in their pocket.
[Owner earnings] represent[s] (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges….and 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 incremental needs to be added to (c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)
Our owner-earnings equation does not yield to the deceptively precise figures provided by GAAP, since (c) must be a guess-and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes-both for investors in buying stocks and for managers in buying entire businesses.
Applied to our Coles example for 2017 ($ in AUD).
(a) $1,609 million + (b) $647 million – (c) $1,948 million (6 year average)
= $308 million (EBIT)
Vastly lower than the reported $1.6 billion dollar (EBIT) figure.
Another important observation Buffett added to the above description is the following:
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.