The one mistake 99% of investors make

I made it too

The earnings conundrum

• When Michael Mauboussin talks about earnings, he means cash earnings

• When Warren Buffett talks about earnings, he means owner’s earnings

• When Joël Greenblatt talks about earnings, he means future normalized earnings

One of the big lessons in investing is nuance. Words spoken by different people have slightly different meanings, but that difference is important.

Let’s look at these 3 greats in finance, study their thinking, and look at companies like ASML, Dino Polska, and Disney.

Cash Earnings

This is the easiest one. Earnings can be manipulated. The CFO and his team's choices can make an income statement look great, and thus the earnings.

There’s even a name for it: “Earnings Management”

Earnings management is the use of accounting techniques to produce financial statements that present an overly positive view of a company's business activities and financial position

Source: Investopedia

Some examples are:

• How is revenue recognized? The time of revenue recognition influences the bottom line

• Choosing to assign expenses to opex or capex

• The income statement has a depreciation line statement. Changing the depreciation from accelerated to straight-line will reduce expenses and increase earnings

• Playing with provisions: Companies can set aside part of the income as provisions as expenses for future liabilities. Provision manipulation can be used to buffer the earnings in a bad year (by reducing the reserves)

• …

It can also go the other way. We discussed a software company in the past that does not capitalize on any software expenses. In other words, their bottom line is understated. 

A high gross margin software company trading at a PE of 7

There is less manipulation possible with the cash flow statement though. 

Profits are an opinion, cash is a fact.

Alfred Rappaport

A simple solution: Always look at the quality of earnings:

Quality = Net Cash Flow from Operations | Net Income

If this number is 80%, then you’re good.

ASML generated 7.84 billion USD in net income and 5.4 in cash. That’s 70%. You can see that overall, the quality of earnings has been pretty good but somewhat lumpy. It’s a consequence of ASML’s business model.

Source: Finchat.io

Owner’s earnings

As an investor, your goal is to think as an owner. If you could buy 100% of the business, what part of the earnings would interest you the most?

Right, the part that you could potentially extract freely if you wanted to.

Net income reported does not take into account investments needed to maintain and ensure future growth. From Berkshire Hathaway’s 1986 annual report:

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) 

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.

So Buffett looks at cash as he adds back all non-cash items to the net income. He then subtracts the average annual amount of CAPEX needed to maintain its long-term competitive position and its unit volume.

He links MOAT analysis to finance and accounting and as he states, the estimate of the amount of investment needed is up to you to guess.

Fantastic MOATS and how to find them

The best way is of course to do this calculation manually. The quickest way is through the cash flow statement.

Owner's Earnings = CFO - SBC - NCI - MNT CAPEX

• SBC stands for Stock-Based Compensation

• NCI ae net income from non-controlling interests

The MNT Capex is the number Buffett is referring to. It’s a guess. You could equate it to the depreciation costs, but this may overstate or understate it. But is this CAPEX spend sufficient to maintain its competitive position? That’s the art part.

A beautiful example of this is Jon Cukierwar's analysis of Dino Polska, the Polish retailer. Here’s the table:

Source: Sohra Peak Capital

He takes the net income, adds back the cash, and then subtracts the maintenance CAPEX. He goes further, and because it takes one store 3 years to reach maturity, he adds the additional mature earnings figure. The result is 3 different price/earnings multiples.

Dino Polska: Where is it headed? A destination analysis

Note: CAPEX for future growth is not included in Buffett’s calculation. In my mind, it makes sense, as he looks for inevitable companies. In other words, he is more interested in the length of the competitive advantage period, than in the growth rate itself. In addition, he does not want to pay up, so he will invest when he knows a lot of the cash flows will fund his investment in the near term. (he won’t pay more than a multiple of 15). All additional growth he gets is a bonus.

Future normalized earnings

When Joel Greenblatt talks about earnings, he talks about EBIT. So he looks a bit higher up in the income statement.

The past is there to inform us. Our returns are made by what the future brings.

From his class notes:

Joel Greenblatt Class

1.88MB ∙ PDF file

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The normalized path is akin to the above discussion on Buffett’s average. If the past informs the future, then we first need to normalize past earnings. This means:

• Looking for one-offs in the statements, non-recurring items. Has the company made any special expenses or investments that should not be there in a “normal” operating year?

• Was there a particular context that unusually influenced business operations, and can be seen as temporary ( typically several companies were boosted by COVID)

• Adjust for cycles: Is the company competing in a cyclical industry? Where is it in the cycle? Can you normalize for cycle impact?

Remember to normalize everything, this means also assessing what a normalized MNT CAPEX looks like. Once we have a pretty good idea of what normal looks like, the last question will be:

• Will tomorrow be as normal as yesterday? 

• Are there trends or developments in the business that could lead to thinking future normalized earnings will be higher or lower?

Once the analysis is done, you can build the owner’s earnings table like Jon did, or put your insights into a DCF. But the most important rule of all:

If you can’t figure out future normalized earnings for a company, put it in the too-hard pile, and pass on to the next.

Let’s look at a well-known company like Disney. Can Disney get back to its normalized earnings?

Disney in the past

Do you think Disney will fully recover?

Disney’s revenue has grown at a 6% CAGR over the last decade. Nothing to get too excited about. However, net income has suffered since 2020. 35% of revenue comes from their parks & resorts. You can already imagine the COVID impact. Revenue for this segment has fully recovered. I don’t know if you’ve been at a Disney park lately, but every time I’ve been there, they are packed to the brim.

Operating margins are recovering, but I’m more interested in the cash flows. Cash flow from operations came closer to 2015 levels. So let’s look at operating cash flows for the last 10 years and see what has happened:

Source finchat.io updated by author

A lot is going on here. As a reminder, to get from net income to cash from operations:

Net income + Noncash items + Changes in Working Capital

• Non-cash items like depreciation are added back to the net income

• A change in working capital is added back (When accounts receivables increase year over year, less cash has been received and clients owe more cash to the business. The number will be negative and has to be subtracted from the net income)

From 2016 to 2018, it looks more or less stable. Then, things change. For the non-cash items: 

• D&A starts increasing

• Amortization of goodwill & intangible assets rises sharply

• 2 assets write-offs in 2020 and 2023 which impacts net income

• I’m not sure what other operating activities are

And for the working capital:

• Bigger changes in accounts payable

• And lastly a large income tax cash outflow in 2019

In addition, Disney has changed their revenue segmentation several times over the last 2 decades, which makes it harder to pinpoint margins for each segment.

Although the overall number’s trend seems to indicate Disney is on some sort of road to recovery, more work is needed. It’s too hard to evaluate in a quick analysis with a high degree of confidence what future normalized earnings will look like. 

Conclusion

Net Income, EBIT, Owner's earnings, cash earnings, and we haven’t even talked about Free Cash flow yet.

Nobody said investing was easy. But in the end, remind yourself that your goal is to be directionally right, instead of precisely wrong. Based on your experience, you take your best guess and look at a lot of companies to hone your craft.

The best advice:

• Stick to a method you can repeat on different companies

• Use the method that is best suited to the company life cycle

• Invest when the undervaluation is obvious, use that margin of safety

Have a great weekend.

May the markets be with you, always!

Kevin