Find out what a business is actually earning for you.
I'm sure that most have heard the old saw, turnover is vanity, profit is sanity and cash is reality.
Anyone who has been involved in running a business will have an acute appreciation of this truth, for when the bills are piling up, it doesn't matter a hoot what the accounts say you are earning if the cash in the bank disagrees!
Cash is king
The maxim is easy to understand when it comes to the bits about turnover and profit.
Less well understood by those who haven't been there, perhaps, is the bit about cash being reality. Surely, profits are real too some might cry, and the answer could be yes, or no.
For many reasons, and due to the oddities of accounting, profits can appear and disappear on an income statement, and it is possible for a business to show a paper profit that doesn't translate into a cash reality during the same accounting period.
There is a great example of this type of thing in the appendix of Warren Buffett's 1986 Berkshire Hathaway Shareholder's Letter.
Buffett made another useful point in that letter when he said:
"... book value at most companies differs widely from intrinsic business value -- the number that really counts for owners."
He went on to argue that good management of a business can increase its earning power -- its ability to generate cash -- without the need to inject more capital.
This improvement in economic value then becomes an intangible asset. For example, if the business were to be sold, the additional value could be listed as 'goodwill.'
It follows that the intrinsic value of a trading business comes down to the value of its tangible assets and its potential ability to generate cash in the future.
However, knowing what to use as the raw material for analysing the cash flow of a business effectively can be challenging.
One way, is to consider its Free Cash Flow. In one definition, this term is understood to mean that part of the generated cash, which is available to return to investors, or for the company to invest for growth.
In other words, the cash left over after deducting the money spent maintaining current operations, but without deducting the money spent investing for growth.
But, Googling the words Free Cash Flow throws up varying interpretations of the term and it can be difficult to know which one to use when valuing a business.
Thankfully, there is clarity at hand in the 1986 Berkshire Hathaway letter.
To Buffett, what we generally know as Free Cash Flow, he calls Owner Earnings, which he defines with a formula involving three categories:
A -- Reported earnings.
B -- Depreciation, amortisation and other non-cash charges.
C -- The average annual capital expenditure required to maintain healthy operations.
The formula is:
Owner earnings = A + B – C
The difficult part of evaluating owner earnings, is achieving an accurate figure for C.
It's true that capital expenditure appears in the cash flow statement of most business accounts, but its hard to anticipate irregular expenditure that may occur once, say, every ten years.
Yet, to achieve an accurate valuation, it's worth getting to grips with the long-term capital expenditure record of a business.
After separating the growth expenditure, it can then be used to help estimate the average annual cost of replacing, improving or refurbishing assets sufficiently, such that a business may maintain its competitive edge.
Buffett cautions that the depreciation etc that is accounted for in B often understates the real capital needs of a business:
"Most managers probably will acknowledge that they need to spend something more than (b) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position."
He argues that ordinary businesses like retailers, manufacturers and utilities, for example, may be able to defer capital spending for shorter periods, but:
"... over a five- or ten-year period, they must make the investment - or the business decays."
Getting to grips with the C part of the formula can often throw up valuations that present the investor with 'unpleasant news,' Buffett reckons.
Margin of safety
In other words, other valuation methods that don't realistically pin down the true value of free cash available, can end up overvaluing a business.
So before plugging your owner earnings estimate into the enterprise value to free cash flow ratio, or into your discounted cash flow calculation, it might be worth remembering his mantra: allow a margin of safety.
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