Samuel Heath - Owner earnings and intrinsic value

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It is important to examine Samuel Heath (LSE:HSM) with an income metric better than conventional profits after tax. Normal earnings fail to properly consider the annual cash outflows which end up being spent on more fixed assets and on working capital items (inventory and receivables in particular) just to support the current strategic market position, and therefore turnover and profits. I’ll use Warren Buffett’s “owner earnings” approach.

The idea behind owner earnings

With owner earnings we are trying to obtain the earnings that, in future, would be left for shareholders after the managers’ use of the cash generated to pay for items of expenditure to maintain the strength of the economic franchise (e.g. additional capital items, additional working capital, marketing spend, R&D and staff training) and to maintain unit volume and to invest in all value-generating projects available.

Depending on circumstances, the owner earnings figure may be the same for every future year or on a steadily rising (or falling) trend.

Naturally, owner earnings are impossible to obtain with any degree of precision because many of the input numbers are merely educated guesses about the future.  Despite this imprecision it remains an important method for thinking through valuations.

Using the past to guess the future

Owner earnings analysis is about future cash available for shareholders to take out of the business.  But the only evidence we have available is past data.  We start with that, and then use qualitative analysis to judge whether to simply project forward the past pattern or modify the previous trend for future orientated thinking.

In the following we use what the company actually invested in new working capital items and in new fixed capital items, and what they spent on marketing, R&D and staff training etc. already deducted from the P&L.

What the analysis really requires is the amount necessary to maintain the quality of the economic franchise, unit volume and invest in value generating projects.  To start with we make the bold assumption that what was spent by the managers was also the necessary amount.

When we move to forward-looking analysis to value the firm we need to make another bold assumption on the real amount needed to invest in new WC, fixed capital items, etc., in the future.  The historical analysis helps us make that judgment.

“Owner earnings” in the past

£ooos              YEAR   2015   2016   2017   2018   2019   2020
Profit after interest and tax deduction 394 769 1,013 980 968 1,069
Add back non-cash items such as depreciation, goodwill and other amortisation 418 369 329 423 375 421
Totals to: Amount available for distribution to shareholders before considering the need to spend on fixed capital items to maintain the company’s economic franchise, unit volume and invest in value generating projects.   812 1,138 1,342 1,403 1,343 1,487
Deduct fixed capital expenditure other than property. And deduct cash invested in working capital.  (The figures shown are actual expenditures and are therefore a rough proxy for the ‘needed’ expenditures to maintain franchise, etc.)  -604 -282 804 -313 +111 -585
Owner earnings 208 856 538 1,090 1,454 902

Average owner earning over the last six years is £841,000.  Will the future be like the past? Now, more than ever, we are uncertain, but we can think in terms of reasonable scenarios.

Scenario 1Recession and recovery

Owner earnings fall to zero for two years. All yea………………To read more subscribe to my premium newsletter Deep Value Shares – click here


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