Tuesday, May 5, 2009

Owner's earnings

Legendary investor Warren Buffet analyses companies not taking into account their reported earnings but by their "Owner's Earnings". This term signifies the net profit that is going to owners of business after taking care of all the needs of operations of business. As per Mr. Buffet,

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. If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c).”

What are the implications of using OE as measure of viewing businesses? Many businesses have high reported earnings (declared net profits) but not any real earnings for their owners (shareholders).

Let’s discuss why OE is a better yardstick to judge business.
Suppose you want to analyze a restaurant business in your locality. Here are the details of that business:
Cost of premises: 50 lakh.
Debt: 25 Lakhs
Interest on loan = 10%
Revenues: 40 lakhs
Cost of raw material: 5 lakhs
Personnel cost: 8 lakhs
Depreciation rate: 15%
Tax rate: 30%

So my reported earnings (NI) would be: (Revenue - Cost of raw materials - Personnel cost – Depreciation-Interest)(1-tax rate)
Putting values we get
(40 – 5 – 8 – 7.5 – 2.5)(1-0.3) = 11.9 lakhs

Using standard P/E multiple of 10-12 we can get the value of this business to be around 120-145 lakhs.
But think from the perspective of an owner of a business. Depreciation shown on the income statement is a non cash expense but never goes out from the coffers of business so we can add that expense to NI.


Earnings available to owner: 11.9+7.5 = 19.4 lakhs.
Now suppose to maintain my premises in good condition I have to invest around 10 lakhs every year on it (painting, fittings, electrical appliances like bulbs/fans/AC etc), so these 10 lakhs are not going into owner’s pockets. Further suppose to keep operations owner has to invest in more cutlery, tables/chairs, more raw material availability to keep customers happy. Suppose this investment is 5 lakhs. Above two expenses are also not going to owner’s pocket so must be deducted from 19.4 lakhs we calculated above.

So Earnings available to owner: 19.4-10-5 = 4.4 lakhs!!!!

Depreciation addition to NP is simple. Expenses to maintain premises is Capital Expenditure (Capex) and expenses to increase raw material and other inventory is Change in Working Capital

So essentially we have done is calculating Owner’s Earnings defined by Mr. Buffet.

OE = NP + Dep + ΔWC - Capex
Where
OE = Owner’s Earnings
NP = Net Profit or Reported Income
ΔWC = Change in working Capital(+ve for increase in WC and –ve for decrease)
Capex = Capital Expenditure
ΔWC and Capex can be calculated from Cash flow statements of company.
If you start calculating OE for companies listed on NSE/BSE, you will be surprised to know the differences in reported earnings and OE.
Here are the calculated OEs for some of well known companies listed on Indian bourses.


















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