Posted by luzeeker > 2014-06-09 16:43 | Report Abuse

hi kcchongnz, when you calculate company’s “owner earnings”, do you take changes in working capital into account?

Posted by kcchongnz > 2014-06-09 17:25 | Report Abuse

luzeeker,
You brought up a good point and made me ponder quite a while. Obviously if you look at the formula I used to calculate Buffett's "owner earnings", it does not include the change in working capital into consideration. This is what Buffett said:

“If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) 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) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)” – 1986 Berkshire letter

My calculation of OE as you can see is a rough one. I didn't include any "other non-cash charges". On one hand I didn't include the additional working capital, but on the other I used the full capital expenses, rather than just the maintenance capex "to maintain its competitive position and unit volume".

If you search through the website there are different opinions on what owner earnings include. It seems more follow my way of determination of Owner earnings.

So what is your view?

Posted by stockoperator > 2014-06-09 17:35 | Report Abuse

if it includes working capital, it looks more like cash flow statements, right?

Posted by stockoperator > 2014-06-09 17:37 | Report Abuse

Despite the technicality, purpose is more important i presumed.

Posted by stockoperator > 2014-06-09 17:41 | Report Abuse

Noted More heavy investment during down Business cycle for next phase of Growth.

Posted by stockoperator > 2014-06-09 17:47 | Report Abuse

Above Ratios pointing to Core Business operating efficiency.

Posted by luzeeker > 2014-06-09 18:06 | Report Abuse

For this quote " (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)", i can understand because if it follows LIFO, it would have been reflected in its cost of goods sold.

Yea, i have seen different opinions on websites. Some equate OE to FCFF and some say it is entirely a different thing. I think the key point here is "if unit volume does not change". But I think that is a hard information to get or if you don't mind to share with me if you know where to find it. IMHO, i think additional working capital is like a additional maintenance capex by itself. The additional working capital occurs when lets just say the inventory cost increases somehow. Because the business will need to reserve some of this earnings for the next earnings cycle. This definitely can't be returned to the shareholders else the business will stop functioning or unit volume would decrease.

I think the same should go to receivables and payable. If lets just say a business need to give looser credits to maintain its competitive position, then i think it should also included as additional WC as well.

But the problem is these information are hard to come by and we can only estimate, i guess. Plus it could just be simply, timing issue. And if it is included in OE, for some we will get a very volatile OE.

To be honest, i am still a little in the dark. Hope by exchanging opinions with you i could get some light. haha

What do you think?

Posted by kcchongnz > 2014-06-09 18:28 | Report Abuse

Actually a lot of Buffet's thoughts were articulated in his shareholders' letter. He never show how to calculate them. Hence there are inevitably many interpretations.

I have tried including to include this change in working capitals throughout the years after your query. Yes, there is some reduction in owner earnings, but it has not affected the conclusion for Pintaras I had in my article in any significant way.

I always follow this principle of "It is better to be roughly right than precisely wrong" in my finance and investment.

Posted by Chin Yong Cheong > 2014-06-09 20:03 | Report Abuse

Hi luzeeker, kcchong, it is an interesting topic. Allow me to express my two cents worth of view.

Let start with a quote:"The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.” - Not quite sure if this quote originate from Warren or John Burr Williams, but the idea of discounted cash flow definitely originate from John.

As an investor, either as a bond holder, preferred stock holder, or commonstock holder, valuation could be different at different stage(i.e.A company bond maybe worth to invest but not necessary its common stock) but the principal is the same. An investor should value his/her investment holding based on the tangible cash they could get back in return. If follow John Burr Williams, it is dividend, as time goes by it evolve to be free cash flow to equity or possibly Warren has rephrased it as Owner Earnings. (cash flow generated from business activities and readily distributable as dividend)

I am not sure if Warren's Owner Earnings is referring to FCFF or FCFE, but I personally is using FCFE to calculate the intrinsic value of the company. I prefer using FCFE because as its name implied, it is the free cash flow to equity (readily distributable as dividend assuming no reinvestment activities) and commonstock holder is always the last to have rights to the company asset's.

The formula for FCFE is Net Income - (Capex - Depreciation) - (Working capital Changes) - (Debt payment) + (New Debt Issued). In my opinion, working capital is not that difficult to estimate as inventory control, day receivable terms, day payables terms shall be under well controlled by management. The trickiest part of all is the company future growth projection.

Posted by luzeeker > 2014-06-09 20:06 | Report Abuse

Haha. I was too into the tenets that i forgot you actually wrote this for Pintaras Jaya. My bad.

Actually i am just seeking your opinion on OE that could help on my other companies analysis. Some have minimal impact, some have significant one.

Yes, you are right. It is better to be approximately right than precisely wrong. Margin of safety could help.

Posted by stockoperator > 2014-06-09 20:34 | Report Abuse

The Ratio basically:

1) filter operating earning against invested capital,
2) then filter profit against Revenue,
3) then filter down to net income to attributed to shareholders.
4) And finally if retained income adds any market value to shareholders.

Cycle continues year after year.

Posted by kcchongnz > 2014-06-10 05:57 | Report Abuse

luzeeker,
Hope I have the chance to continue to exchange ideas with you.

Posted by kcchongnz > 2014-06-10 06:17 | Report Abuse

Chin Yong,
Thanks for your comments. Just a couple of points here.

Owner earnings is definitely related to equity holder and so FCFE will be the closest resemblance of owner earnings.

Your equation of (initiated by Michael Jensen?)

FCFE is Net Income - (Capex + Depreciation) - (Working capital Changes) - (Debt payment) + (New Debt Issued)

to me is a little academic. Yeah I know people are taught this way when they take their CFA certificate. But when I investigate an investment thesis, I dare not take the last two terms into consideration.

I can't swallow the notion that a firm takes in more and more debts, and in the process endanger its risk of bankruptcy, can benefit its equity shareholders by increasing their FCF.

Posted by Pak Lah > 2014-06-10 17:32 | Report Abuse

Many thanks kcchongnz for the above highlights. Ptaras have today won another sizeable piling works in KL, bringing the book order to RM332mil, i.e. this figure is double of its book order of last year. The management is of good quality (both competent + honest) are bringing cheers to everyone!