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In the context of Scott Fetzer Buffett explained what he meant by owner earnings, which is the best measure of money generated for shareholders, and is the key input to intrinsic value estimation:
“(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).” (1986 letter, appendix)
He hastens to add that this equation will not lead to precise figures, “since (c) must be a guess – and one very sometimes very difficult to make”. Nevertheless, owner earnings remains the key to establishing valuations for both individual shares and entire companies. He quotes John Maynard Keynes “I would rather be vaguely right than precisely wrong.”
When it comes to Scott Fetzer, Munger and he judged that element (c) was very close to $8.3m which, in this particular case, is exactly the same as the company deducted for “Depreciation of plant and machinery” in its formal accounts for 1986, i.e. element (b) in the equation. In other words, the using up of capital items (tangible and intangible) roughly matches the expenditure needed on new capital items to maintain unit volume and the quality of the competitive position. Implicit in there is that they also judged that, in this case, there is no need to add to the amount tied up in working capital year on year.
Table 5.2. Buffett’s owner earnings estimate for Scott Fetzer for 1986
| $m | ||
| (a) Reported earnings | 40.2 | |
| Plus (b) depreciation, depletion, amortization, and certain other non-cash charges | +8.3 | |
| Minus (c) amount needed to be spent on plant and equipment and incremental working capital the business requires to fully maintain its long-term competitive position and its unit volume. | -8.3 | |
| OWNER EARNINGS | 40.2 |
Buffett warns that most managers will need to spend more under (c) than is shown under (b) simply to trend water in terms of competitive position and unit volume. In these cases, reported earnings will overstate owner earnings, often substantially so.
See’s Candies has different investment needs
Buffett illustrates (1986 letter), using See’s Candies, the need for thought about capital item and incremental working capital expenditure
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