How to Make Sense of And Calculate Owners Earnings

Fajasy
Updated: May 28, 2020

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Disclaimer

Owners earnings, or cash flow for owners, is a figure that is commonly used for intrinsic value calculations, and is one of the best figures to depict how much cash one can get out of an investment.

Most investors use earnings per share (EPS), net income, or some other figure to assess the cash generated for investors. However, the number that Warren Buffet uses is called "Owners Earnings," which is a figure that many investors are unfamiliar with.

Investors make money in the stock market in two ways (in general):

  1. Capital appreciation: When the stocks an investor owns appreciates in value overtime, and the investor sells the stocks to profit the difference.
  2. Dividend payments: Payments that dividend-paying companies give out to investors for holding their stock.

As an investor, you can analyze the cash flows within companies on the stock market, and analyze this to see how these internal cash flows convert into capital gains and dividends.

In the process, you will be able to better value a company and determine its earnings, which will allow you to make more informed investment decisions.

Owners earnings is therefore one of the best figures you can use to determine how much cash goes back to the company owners, and the real dollar amount owners can withdraw without harming operations.

So, in this article, I will show you how to make sense of and calculate owners earnings, and all of its components. I will also provide you with several examples along the way.

Owners Earnings Formula

Owners Earnings = Operating Cash Flow - Maintenance Capital Expenditures (CapEx)

The two components of this formula are operating cash flow and maintenance capital expenditures (aka; CapEx).

So, let's go through each of these two components and understand what they are and how you can go about finding them.

Operating Cash Flow

Operating cash flow is otherwise known as "net cash provided by operating activities," "net cash generated by operating activities," or something similar along those lines.

This is the easier component of the formula, as this figure is already calculated and provided to us by companies in their annual reports.

So, go to your chosen company's investor relations page, click on any 10-K annual report, and scroll down until you find the "statement of cash flows" or "cash flow statement."

If you're having trouble finding your company's annual report or want to become more familiar with 10-K annual reports before proceeding, I would recommend reading this article on How to Read and Analyze Any 10-K Annual Report.

The statement of cash flows has three sections:

  • Operating Activities
  • Investing Activities
  • Financing Activities

The number we're looking for is the "net amount of cash generated by operating activity." This is shown on the last line under operating activities, or the first section of the statement of cash flows.

This is also outlined below, with Microsoft's (MSFT) most recent cash flow statement as an example:

The Operating Activities section shows investors the real cash inflows and outflows that are related to the normal operations of the business. This includes the costs of running the business on a day-to-day basis, and includes the costs associated with sustaining the company's core business model.

For the first component of the owners earnings formula, you should look at the net cash generated from your company's normal operations. In our case, I will use the most recent figure ($52,185 Bil.) for this example.

The Financing Activities section shows all the cash flows related to financing. This includes raising debt, paying down debt, delivering capital to shareholders, paying dividends, raising shares, and buying back shares.

In short, when financing-related capital is moved within the business, it will appear under this section.

The Investing Activities section includes cash flows that are used to purchase assets that the company expects to produce value for many years to come. This is where companies spend their money and invest it on purchasing buildings, machinery, and even making acquisitions.

Capital Expenditure Overview

After locating the operating cash flow from the operating activities section of the cash flow statement, the next step is to find and subtract the maintenance CapEx. Again, this will allow for us to compute owners earnings.

Unfortunately, companies typically do not outright provide maintenance CapEx in their 10-K annual reports. Therefore, this number is a little bit trickier to solve, unlike the operating cash flow number which is always provided.

But first, before learning how to compute maintenance CapEx itself, it's important to begin with just total CapEx.

Capital Expenditure

Capital expenditure (total CapEx) is considered an investing cash flow on the cash flow statement.

As mentioned before, this is where companies are spending their money and purchasing long-term assets which they hope to provide value for the business over the long-term.

Total CapEx is therefore considered as an investing activity and relates to buildings, property, plant, and equipment. As you can probably guess, this is commonly referred to on the cash flow statement as property, plant and equipment (PP&E).

Therefore, if you see a line on the cash flow statement called "cash spent on property plant and equipment," or something similar, this is essentially what capital expenditure is.

For Microsoft, this is shown as "Additions to property and equipment" as outlined below:

So, Microsoft had $13.925 billion of total CapEx in 2019.

Sometimes, the number shown here is not the actual total CapEx amount.

For example, for Apple (AAPL), a massive multinational technology company (which I'm sure you've heard of), the number for capital expenditure (PP&E) that is shown on the cash flow statement is not accurate. Instead, you have to do a search for "capital expenditure" in their 10-K annual report to find the actual number.

Therefore, I would recommend searching the term "capital expenditure" or "capital assets" when you are seeking this information for any company, just to ensure the cash flow statement's accuracy.

The Components of Total Capital Expenditure

Now that we have the total CapEx number, the next step is to figure out maintenance CapEx. What this really means, is that we need a sub-section of this total CapEx number.

In reality, total CapEx falls into two categories:

  1. Growth CapEx: When companies spend money to grow and improve their business, in an attempt to produce more cash in the future, this is considered a growth CapEx. This includes any investments made for building purchases or upgrading company equipment.
  2. Maintenance CapEx: This is the figure that we're trying to find, and it's how much money the company is spending just to maintain the business and its operations. For example, if a piece of machinery were to break down, the company would spend money to restore it. Because restoring this piece of machinery doesn't improve the cash flows of the business, and is not seen as an investment that grows the business, it's considered a maintenance CapEx.

Some companies actually make a distinction in their annual reports as to how much was spent on maintenance and how much was spent on growth.

For example, management in the annual reports may say:

"Total capital expenditure was $100 million for 2019. We spent about $60 million maintaining the business and $40 million on growth potential."

Below is an example of Phillips 66 (PSX), a large energy manufacturing and logistics company, where growth and maintenance CapEx are described and separated:

Outlined above are the total cash from operating activities number, which can also be seen on the cash flow statement, and the total $5.3 billion Phillips 66 expects to budget for its growth CapEx category.

The operating excellence, or maintenance CapEx, is what we have to solve for. We can do this with the provided total CapEx ($5.764 Bil.) found in the cash flow statement:

Therefore, Phillips 66's maintenance CapEx for 2016 would be $464 million ($5.764 Bil. - $5.3 Bil).

Then, using the $5.713 billion in cash from operating activities (in specific), we can subtract the $464 million to solve for owners earnings. This would result in $5.249 billion in owners earnings.

Unfortunately, most companies, including Microsoft, do not provide this much information in their annual report.

Therefore, as investors, we have to make an educated estimate on what is maintenance and what is growth from the total CapEx number. This will allow for us to make a more accurate owners earnings calculation.

The Shortcut to Maintenance Capital Expenditure

If you do not want to go through the trouble of estimating the portion of maintenance and growth from the total CapEx number, the most conservative method you can use is to simply assume that all of the total CapEx (PP&E) amount is maintenance.

If you solve for owners earnings in this manner, you will actually come up with a number called free cash flow (FCF):

Free Cash Flow (FCF) = Cash from Operations - Total Capital Expenditures (CapEx)

FCF is the cash available to repay debt and make dividend payments after operating expenses and capital expenditure requirements are paid off.

You can just use the FCF number if you don't want to spend your time figuring out the specifics of the growth and maintenance CapEx numbers.

However, I would highly suggest that if you want to more accurately come up with good valuations of businesses, then you should try your best to learn how to distinguish between growth and maintenance CapEx.

How to Find Maintenance Capital Expenditure

For companies where growth and maintenance CapEx are not distinguished, you will have to estimate this maintenance CapEx figure to solve for the owners earnings figure.

If you have not already done so, the first step is to locate the total CapEx number, as previously covered.

The next step is to figure out what proportion of this total CapEx number is maintenance, and what proportion is growth.

Besides management outright telling us the proportions of maintenance and growth CapEx (as shown in the Phillips 66 example), there are two ways management will talk about maintenance CapEx in the 10-K annual reports:

Maintenance CapEx is Implied

Management commonly implies the growth and maintenance CapEx figures. This is when maintenance CapEx is stated, in some way or another, but not in a clear fashion.

In other words, maintenance CapEx is merely implied or suggested through the way management has written it, and not clearly given. Therefore, it's not clear on how much exactly goes towards growth or maintenance CapEx.

An example of this is Jack In The Box (JACK), a large fast food restaurant chain. As you can see in the image below, CapEx is broken down into multiple categories and a description. For this particular example, you can focus your attention on the outlined area:

For Jack In the Box, you could therefore assume that the following are growth CapEx numbers, as money is being spent to grow the business:

  • New restaurants
  • Purchases of assets intended for sale or sale and leaseback
  • Other, including facility improvements
  • Information Technology (for both restaurants and corporate services)

On the other hand, you can likely infer that only "restaurant facility expenditures" is maintenance Capex, as it relates to the operational expenses required to sustain the business.

Although this estimation may not be the most accurate, I used the description below the total CapEx number(s) and my knowledge on growth and maintenance CapEx to make the best judgement I could.

As you just saw, this differentiation is not always super clear or explicit, and those who are more knowledgeable about a particular business and the industry it's in will be better able to estimate this maintenance CapEx number.

Maintenance CapEx is Not Provided

Often times, management will simply not say anything about maintenance CapEx in their 10-K annual reports. Instead, they would only list their total CapEx number and would provide any information on what they spent their money on.

This is when we are forced to make more vague maintenance CapEx estimations, or take the longer approach and attempt to calculate it as discussed in next section.

There are two general things you can do when maintenance CapEx is not given or implied:

  1. Estimate a Percentage: You would estimate the percentage of maintenance and growth CapEx based on the business and industry knowledge you have. If you read through the most recent 10-K annual report, management will likely make a few comments on CapEx spending, which can help you make a more accurate estimation.
  2. Assume All of CapEx is Maintenance: You can be extremely conservative and approach the problem in this manner, and calculate free cash flow (FCF) as mentioned before. However, if you were to do this, you would assume nothing is being spent on growth, even though this does not necessarily hold true. Regardless, this is what I would recommend doing if you are in doubt and cannot make an accurate percentage estimate.

If you want to avoid vague maintenance CapEx estimates, or if you want to double-check any assumptions you may have made, then it's never a bad idea to read the next section where formulas will be used to calculate maintenance CapEx.

However, if you feel confident in the maintenance CapEx you have estimated, there is nothing wrong with computing owners earnings from here on.

How to Calculate Maintenance Capital Expenditure

The quickest way to calculate maintenance CapEx is to just use a figure called "depreciation and amortization," found on the financial statements, as these account for the diminishing value of an asset over time.

Maintenance CapEx = Depreciation and Amortization

Although you can use this as a solution, there is one major flaw (if not more).

The problem, is that depreciation can be misleading at times, which can lead to an unrealistically high number for maintenance CapEx calculations.

Accounting-related depreciation is misleading, as it can be higher due to price reductions from technological advancements. Depreciation can also be lower in an inflationary environment, where reproduction costs are higher.

Therefore, although it's a more involved process, using Bruce Greenwald's method of calculating CapEx is the next step you should take, as it works towards finding true depreciation.

Bruce Greenwald's Maintenance CapEx Calculation

Bruce Greenwald is widely recognized for his authority on value investing, and his method for calculating maintenance CapEx is ideal when it's not provided in the 10-K annual reports, or if you cannot make an accurate estimation.

In Bruce Greenwald's book: Value Investing: From Graham to Buffet and Beyond, he describes how you can go about calculating maintenance CapEx. This is summarized in the bullet points below: (Source)

  • Calculate the average gross property, plant and equipment (PP&E)/Sales ratio over 7 years.
  • Calculate current year's increase in sales.
  • Multiply the PP&E/Sales ratio by the increase in sales to get growth CapEx
  • Subtract the computed growth CapEx from the CapEx figure (in the cash flow statement) to get maintenance CapEx, which is the true depreciation for the company.

Now, I will use Microsoft's actual Sales and PP&E (total CapEx) numbers from their past seven financial statements, so that I can calculate their maintenance CapEx (which is not given on their annual reports).

The table below shows how you can go about setting up Greenwald's method for calculating maintenance CapEx, in this case for Microsoft:

$MSFT2013201420152016201720182019
Sales$77,849$86,833$93,580$91,154$96,571$110,360$125,843
Change in Sales$8,984$6,747($2,426)$5,417$13,78915,483
PP&E (CapEx)$4,257$5,485$5,944$8,343$8,129$11,63213,925
Change in P&E (CapEx)$1,228$459$2,399($219)$3,5032,293
PP&E/Sales Ratio5.47%6.32%6.35%9.15%8.42%10.54%11.07%
Growth CapEx$736.69$553.25($198.93)$444.19$1,130.70$1,269.61
Maintenance CapEx$491.31($94.25)$2,597$230.19$2372.30$1,023.39
*Values are in millions of U.S. $

The completed table is above, but I've broken this down into steps as well.

Step 1: The first step is to find the revenue (sales) and the plant, property and equipment (PP&E), which we also know as total CapEx, for the last seven years. This information is found on the income statements and cash flow statements.

Step 2: The next step is to divide PP&E/Sales. This will provide you with a ratio that shows how much the company needs to invest in PP&E to generate $1 of sales. For example, in 2019 Microsoft needed about $0.11 in PP&E to generate $1 in sales ($13,925 / $125,843)

Step 3: Average the PP&E/Sales ratio from 2013 to 2019, to normalize company movement and distortions caused by business cycles. For Microsoft, this comes to 8.2% or 0.082, which we will then use to compute growth CapEx

Step 4: Compute growth CapEx using the 8.2% or 0.082 figure. You can do this for every year. For example, in 2019, this would be $1,269.61 in growth CapEx ($15,483 x 0.082). Note that although we have 7 years worth of sales and PP&E (total CapEx), 2013 data is only used to calculate the average PP&E/Sales ratio and the annual changes for Sales and PP&E.

Step 5: Finally, solve for maintenance CapEx by taking the change in PP&E (total CapEx) and subtracting the computed growth CapEx figure for the year. For example, in 2019, this would be $1,023.39 ($2293 - $1269.61). The latest CapEx figure is also the most relevant for computing owners earnings, unless you are trying to value a previous year.

This method works best for companies that are relatively consistent, but not for companies who experience a sales growth number greater than the PP&E (total CapEx) figure. It also doesn't work well for commodity-based businesses.

As seen in the table above, maintenance CapEx can be negative as well (for 2015), due to the small annual change in PP&E (total CapEx). This only makes it more confusing to analyze.

Therefore, this method is not a perfect solution to finding the maintenance CapEx number. Regardless, it's the best method out there, and can be utilized when all else fails.

However, if you're not confident in the solution you arrive at using Greenwald's method, then just stick with using the total CapEx figure.

The Bottom Line

After computed, the owners earnings figure can be applied to your intrinsic company valuations, to help determine whether a stock is overvalued or undervalued.

Owners earnings is also arguably superior to the more popular earnings per share (EPS) number that many investors use. Therefore, it's in your best interest to become comfortable with finding maintenance CapEx, among other things, so that you can make more informed and accurate investment decisions in the future.

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