This article will introduce my research on what we will call "Owner Earnings Yield." I have chosen IBM (IBM) in order to introduce this research, as it is one of the largest holdings of Warren Buffett's company, Berkshire Hathaway (BRK.A). Since owner earnings is Mr. Buffett's innovation, I cannot imagine a better way to test its validity, than to test it on Mr. Buffett's purchase.
On February 27, 1987, Warren Buffett released his 1986 Letter to Shareholders as part of the Berkshire Hathaway Annual Report for that year. That letter was probably one of his better-known pieces written as CEO of Berkshire Hathaway (BRK.B) because it included a special section at the very end called:
Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy
Mr. Buffett provided, in essence, a tutorial on how both he and Charlie Munger select the important information in a company's financial statements. In doing so, he basically gave us their formula on how to successfully analyze companies. Here is that paragraph:
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. 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 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."
From Mr. Buffett's 1986 Letter to Shareholders, we now have an additional way of calculating free cash flow or "owner earnings" as Mr. Buffett calls it. This formula when broken down to its core ingredients is very different from the calculations that are commonly used by analysts on Wall Street in calculating free cash flow.
The difficult part in Mr. Buffett's owner earnings calculation is that he has to factor in changes in working capital, which are not a one-step process, but require the following items to be factored in:
Increases/Decreases in the following:
- Pre-Paid Expenses
- Other Current Assets
- Other Current Liabilities
- Other Working Capital
And then factor in other non-cash items like stock based compensation for example.
Using Mr. Buffett's owner earnings formula, the results for IBM are shown in the following table:
Now that we have the owner earnings data for IBM, I will introduce the "Owner Earnings Yield," which is similar to the "Free Cash Flow Yield" that I introduced in my recent article on Apple (AAPL). Instead of using free cash flow per share in the numerator, I have replaced it with owner earnings per share.
IBM has been a very conservative investment over the last decade, as its owner earnings yield has averaged around 8% (2488 trading days) and currently yields about 9%. The way to calculate owner earnings yield is by taking IBM's owner earnings per share and dividing it by the current market price. So for example, at the market bottom of March 2009, IBM had an owner earnings per share number of $10.67 and a stock market price per share of $81.71, thus if we divide $10.67/$81.71, we get an owner earnings yield of 13%. But if we were to go back to 11/20/2008, you would have seen IBM trading at $65.47 with an owner earnings yield of 14%.
In conclusion, if we were to take our analysis forward and use IBM's trailing twelve months results, we get IBM earning $19.66 in owner earnings per share and with a current stock price of $187.74, we would get a projected owner earning yield of $19.96/$187.74 = 10.63%, which is excellent. This would also give us a much higher yield than what Mr. Buffett was looking at when he finished buying up his shares of IBM a few years back. If IBM's management can beat the analyst estimates when it reports on January 21st, then I see shares rocketing back up to previous highs. If it doesn't then the downside should be limited, as the stock has already sold off from its high of $215.90 that it achieved back in March of 2013. Management has had more than enough time to fix the various problems that IBM experienced since early 2013 and I believe that the company should exceed analyst's estimates this time around. That is why IBM is one of the largest holdings in my client portfolios. I look forward to next Tuesday's earnings report and expect strong results.