▶ Full Post Text
Fair warning to those readers who are AI averse, I did use AI to assist me in putting together some of this write up as I am primarily an investor and not a writer and it saves an immense amount of time in formatting and laying out the models.
Company A
• Market Capitalization: $1,000,000
• Reported Net Income: $100,000
• GAAP P/E Ratio: 10.0x
• GAAP Earnings Yield: 10.0%
Company B
• Market Capitalization: $1,000,000
• Reported Net Income: $80,000
• GAAP P/E Ratio: 12.5x
• GAAP Earnings Yield: 8.0%
Based on this alone, Which company would you rather buy? If you picked company A you would be wrong, and here is why.
OWNER EARNINGS as Warren Buffett originally wrote in Berkshire Hathaways 1986 letter to shareholders,
To find the true cash available to shareholders, we apply the Owner Earnings formula:
(Net Income + Depreciation & Amortization - Maintenance CapEx).
Company A Calculation (The "Treadmill" Business)
• Reported Net Income: $100,000
• (+) Depreciation & Amortization: $70,000
• (–) Required Maintenance CapEx: ($120,000)
• Total Owner Earnings: $50,000
Company B Calculation (The "Asset-Light" Business)
• Reported Net Income: $80,000
• (+) Depreciation & Amortization: $5,000
• (–) Required Maintenance CapEx: ($2,000)
• Total Owner Earnings: $83,000
TRUE ECONOMIC YIELD
When we look at the actual cash "left in the register" after necessary reinvestment, the valuation flip-flops.
Company A
• GAAP Earnings Yield: 10.0%
• Owner Earnings Yield: 5.0%
Company B
• GAAP Earnings Yield: 8.0%
• Owner Earnings Yield: 8.3%
Company A is a "Value Trap." Half of its reported earnings are not actually available to owners; they are a mandatory cost of staying in business.
Company B, despite looking more expensive on a P/E basis, is actually the cheaper stock because it generates significantly more spendable cash for the investor.
Amortization costs from acquisitions can also often make a companies headline P/E ratio seem very expensive but if you filter out the “accounting noise” and look at the economic reality for the owner it gives a much clearer picture.
To quote Charlie munger
“There are other businesses, like the construction equipment business of my old friend John Anderson. And he used to say about his business: 'You work hard all year, and at the end of the year there’s your profit sitting in the yard.' There was never any cash. Just more used construction equipment. We tend to hate businesses like that."
GAAP P/E ratios may seem at first to represent the actual earnings of a business, yet in reality they do a poor job of it, to my advice is to “think like an owner” and use owners earnings to come up with the economic reality of earnings that are produced by the business you are looking at buying,
If anyone has any comments or suggestions to this frame of thinking I would love to hear it, if you made it this far, I hope you enjoyed my little write-up