(This post is republished with permission by Peter George Psaras, portfolio manager of Conservative Equity Investment Advisors.)
On February 27, 1987 Mr. Warren Buffett introduced in the Appendix of Berkshire Hathaway’s 1986 Annual Report section the following:
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.)
Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since(C) must be a guess – and one sometimes very difficult to make.
Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses.
We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”
In that statement Mr. Buffett also points out that “Our owner-earnings equation” and that “we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses.”
We obviously can only conclude that both Mr. Buffett and his partner Mr. Charlie Munger use this owner earnings equation in selecting stocks and in buying entire businesses.
My goal in writing has always been to try to teach as many investors as I can how to analyze stocks properly and in teaching about Mr. Buffett’s owner earnings ratio.
Definition of Free Cash Flow and Owner Earnings
Jae previously wrote how owner earnings is calculated in the following way:
+ depreciation, amortization
+/- other non cash charges
– (C) annual maintenance capex (or the full capex depending on whether you are able to calculate it or not)
+/- changes in working capital
The owner earnings interpretation above is the best I have seen and is similar to the one I have been using for years.
Not only that but the article linked to above details its components and shows where each came from in Mr. Buffett’s statement above.
Before I show you Apple’s owner earnings, let me first also define what free cash flow is as we will be comparing Apple’s free cash flow to its owner earnings as part of this demonstration.
The standard free cash flow analysis commonly used today is calculated in this way:
So let’s see how to analyze Apple (AAPL) using these numbers.
Analysis of Apple Using FCF and Owner Earnings
Let us first begin by displaying the data for each equation:
Followed by a chart representing the data above:
I always like to view comparative data on a per share basis, so here is a table displaying Apple’s diluted shares outstanding for each of the years in question.
Diluted shares outstanding is used as it gives me a complete representation of all shares outstanding as the following definition will show.
Now that we have Apple’s diluted shares outstanding, we can thus calculate the per share data for its free cash flow and owner earnings.
Followed by a chart representing the data above:
Some years ago I did a backtest on the power of free cash flow in the investment process, which you can download with this link. It’s titled Price to Free Cash Flow Backtest 1950-2009.
In that analysis I went back to 1950 and analyzed the Dow Jones Industrial Average components over 60 years on a price to free cash flow basis and the conclusion I came to was that when an investor bought a stock at 15 times or less its price to free cash flow or owner earnings, that investor increased her chances of success dramatically.
Therefore when looking at stocks to buy I always multiply the per share data by 15 and try to find points of entry below that price point. The following is the price history of Apple vs. its owner earnings and free cash flow per share data multiplied by 15.
Followed by the data that was used to create the chart above:
Obviously using the system above explains a lot as to why Apple has been such an incredible investment for those who invested in it. Going forward I believe that Apple is still undervalued and thus I own it for my clients.
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The Secret to Apple’s Success
The secret to Apple’s success comes from the fact that the company makes products that people love to own, but more importantly management understands that the company is also in business to make profits and will only come out with products that have strong profit margins.
One of the major downfalls that led to the demise of Nokia, who was a pioneer in smartphones years before the first iPhone came out, was that management dropped the ball as it had an obsession with market share instead of concentrating on profit margins.
When you add in amazing design with giving the customer what they want or need, Apple can keep margins high and since they operate now through “Economies of Scale“, the more product the company sells the cheaper in becomes (per unit sold) to produce and thus management is able to improve profit margins.
Market share is good to have, but without strong profit margins, market share cannot be sustained as you don’t generate the necessary profits to allow the company to grow. Apple also continues to produce incredible increases in free cash flow and is expected to produce $64.5 billion in free cash flow for 2015 (when one analyzes it from a trailing twelve month perspective).
Despite the fact that I have been a skeptic for a while, as I could not believe that the company, with a $732 billion market capitalization, could sustain its growth rate and thus felt it had limited upside.
I was proven wrong and thus I have repurchased Apple stock as the latest announcement that the company would return $200 billion to shareholders, changed my mind.
I now believe that Apple could at a minimum be the first company to hit the $1 trillion market capitalization mark.
I will re-evaluate it when it does so, but as for now Apple is a keeper as long as the company continues to concentrate on profit margins.
The author is long AAPL and a member of Old School Value.
Re-posted with permission from author. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.