It isn't too dissimilar to Buffett's 'owner earnings'. If you look up the Berkshire Hathaway 1986 shareholder letter, he explains it in there. This is my variation of that metric. Volatility is smoothed over time using moving averages. D&A are added back as these are accounting works of fiction. CAPEX is split into growth and maintenance, with only the maintenance element being subtracted (the growth part is capital allocated for the future benefit of shareholders which could instead have been paid out as dividends rather than being retained, so doing it this way becomes capital allocation neutral).
If you've studied John Malone (the guy who introduced the phrase EBITDA into the the financial lexicon) you will have a better understanding of why this provides a better picture of the business.
Imagine that you have two companies in parallel universes with identical unit economics.
Company A reinvests heavily in growth meaning that net earnings are low because of all the investment expenditure, while Company B optimizes for earnings by investing nothing in growth.
On the face of it, most myopic investors would look at the far better earnings of Company B, and so invest in that company.
That would be the wrong decision.
All else being equal, after 10 years, Company B will be the same size as it hadn't invested in growth, while Company A would be far larger and more successful.
So GAAP numbers are entirely misleading for an investor.
To normalize these numbers in the course of your analysis, you have to ascertain the earnings power of both businesses (which is how much they would earn if they were not reinvesting in growth). This would have revealed that in year 1 both companies had equal earnings power. With that in mind, you would have made not a quantitative assessment of which to invest in, but a qualitative assessment. Company A would appear better because it was allocating capital for the future whereas Company B was not.
So we are interested in earnings power, which is why I remove growth capex from my numbers. Most people don't get it, which is why most missed the boat with Amazon. Everyone claimed that its earnings multiple was too high, but that was because its GAAP earnings were suppressed by reinvestment activity. Its real earnings power was far greater and it is this number that ought to have been used for assessing the earnings multiple.
Warren Buffett makes the same adjustments. See his 1986 shareholder letter where he explains "Owner Earnings".
You may also be interested in these articles on related topics:
Hi James, thanks for the detailed response. I guess the difficulty lies in stripping out the growth investment within operating expenses. Similar issues with capex investment though...
Are you adding back D&A here? These are operating leases which are no longer in operating expenses, so from my understanding, these should not be added back to get onwer earnings in this instance.
The period over which an asset is depreciated is entirely discretionary and allows creative accountants latitude to play with their earnings (either to flatter the accounts or, if competent, to mitigate tax liabilities). Not very useful for an investor either way.
It is even more misleading in inflationary times such as today as the replacement value of assets far exceeds the D&A calculated on an historic cost basis.
I look at actual CAPEX, run moving averages, factor in inflation, and come up with a far moire reliable number.
I understand why you would mostly ignore it. But when regular expenses are going through D&A - and you choose to ignore it - you are overstating earnings.
In regards to ANX, ~90% of D&A relates to vehicle hire which is essentially an operaing expense. Are you really ignoring this in your earnings calculation?
The issue with family run businesses is that they are family run!
Think about this. For a company to succeed, it needs to ensure it always has the best leadership. Just like a sports team needing the best coach. The founder was instrumental in creating the business, but when his reign comes to an end, of the 7 billion people on the planet, what are the chances that one of his children are the best choice to lead the business?
Just because the family inherits ownership of a business, does not mean that they inherit the ability to manage it and drive it forward.
The best family businesses split ownership and management. The family retain their ownership stake, while management decisions are delegated to someone else (the best person for the job).
Nepotism is a drag on performance.
This family are not bad managers, but their capital allocation decisions are influenced by personal preference, not by what is best for the business. Dividends should not be mandated and, as I argue in my book (Fabric of Success), should be a last resort form of capital allocation where none other is available. For this company, they do it the other way around. It is back to front, upside down thinking.
Therein lies the problem.
The other issue with this business being run as a family heirloom is that it is unlikely to ever be acquired. It would perform far better under different ownership, but the family won't let it go. For them it is a cash cow that keeps yielding milk. Why sell the cow?
How are you calculating economic earnings? thanks
It isn't too dissimilar to Buffett's 'owner earnings'. If you look up the Berkshire Hathaway 1986 shareholder letter, he explains it in there. This is my variation of that metric. Volatility is smoothed over time using moving averages. D&A are added back as these are accounting works of fiction. CAPEX is split into growth and maintenance, with only the maintenance element being subtracted (the growth part is capital allocated for the future benefit of shareholders which could instead have been paid out as dividends rather than being retained, so doing it this way becomes capital allocation neutral).
If you've studied John Malone (the guy who introduced the phrase EBITDA into the the financial lexicon) you will have a better understanding of why this provides a better picture of the business.
I explain it in more detail in a chapter of my book https://www.amazon.co.uk/Success-Stock-Market-professional-investor-ebook/dp/B088FXWJK4
I hope that this helps.
Hi James, if we remove growth capex from our models but include the growth in revenue and earnings are we not getting this growth for free?
BTW I also have a write up on Anexo (and a few others) but I decided to unpublish them in the end. I'd be happy to discuss them with you :)
Thank you for your comment.
Imagine that you have two companies in parallel universes with identical unit economics.
Company A reinvests heavily in growth meaning that net earnings are low because of all the investment expenditure, while Company B optimizes for earnings by investing nothing in growth.
On the face of it, most myopic investors would look at the far better earnings of Company B, and so invest in that company.
That would be the wrong decision.
All else being equal, after 10 years, Company B will be the same size as it hadn't invested in growth, while Company A would be far larger and more successful.
So GAAP numbers are entirely misleading for an investor.
To normalize these numbers in the course of your analysis, you have to ascertain the earnings power of both businesses (which is how much they would earn if they were not reinvesting in growth). This would have revealed that in year 1 both companies had equal earnings power. With that in mind, you would have made not a quantitative assessment of which to invest in, but a qualitative assessment. Company A would appear better because it was allocating capital for the future whereas Company B was not.
So we are interested in earnings power, which is why I remove growth capex from my numbers. Most people don't get it, which is why most missed the boat with Amazon. Everyone claimed that its earnings multiple was too high, but that was because its GAAP earnings were suppressed by reinvestment activity. Its real earnings power was far greater and it is this number that ought to have been used for assessing the earnings multiple.
Warren Buffett makes the same adjustments. See his 1986 shareholder letter where he explains "Owner Earnings".
You may also be interested in these articles on related topics:
https://rockandturner.substack.com/p/john-malone-learn-from-the-best
https://rockandturner.substack.com/p/value-investors-are-barking-up-the
In relation to Anexo, please do share any insights and thoughts that you have. If you could put them in the comments of the Anexo thread, then others will benefit from them also: https://rockandturner.substack.com/p/anexo-a-charlie-munger-fat-man-opportunity
Thank you in advance
Hi James, thanks for the detailed response. I guess the difficulty lies in stripping out the growth investment within operating expenses. Similar issues with capex investment though...
Are you adding back D&A here? These are operating leases which are no longer in operating expenses, so from my understanding, these should not be added back to get onwer earnings in this instance.
D&A is an accounting fiction. I don't use it.
The period over which an asset is depreciated is entirely discretionary and allows creative accountants latitude to play with their earnings (either to flatter the accounts or, if competent, to mitigate tax liabilities). Not very useful for an investor either way.
It is even more misleading in inflationary times such as today as the replacement value of assets far exceeds the D&A calculated on an historic cost basis.
I look at actual CAPEX, run moving averages, factor in inflation, and come up with a far moire reliable number.
I hope that this helps.
I understand why you would mostly ignore it. But when regular expenses are going through D&A - and you choose to ignore it - you are overstating earnings.
In regards to ANX, ~90% of D&A relates to vehicle hire which is essentially an operaing expense. Are you really ignoring this in your earnings calculation?
The issue with family run businesses is that they are family run!
Think about this. For a company to succeed, it needs to ensure it always has the best leadership. Just like a sports team needing the best coach. The founder was instrumental in creating the business, but when his reign comes to an end, of the 7 billion people on the planet, what are the chances that one of his children are the best choice to lead the business?
Just because the family inherits ownership of a business, does not mean that they inherit the ability to manage it and drive it forward.
The best family businesses split ownership and management. The family retain their ownership stake, while management decisions are delegated to someone else (the best person for the job).
Nepotism is a drag on performance.
This family are not bad managers, but their capital allocation decisions are influenced by personal preference, not by what is best for the business. Dividends should not be mandated and, as I argue in my book (Fabric of Success), should be a last resort form of capital allocation where none other is available. For this company, they do it the other way around. It is back to front, upside down thinking.
Therein lies the problem.
The other issue with this business being run as a family heirloom is that it is unlikely to ever be acquired. It would perform far better under different ownership, but the family won't let it go. For them it is a cash cow that keeps yielding milk. Why sell the cow?