N Brown - Owner earnings analysis

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With owner earnings we are trying to obtain the earnings that, in future, would be left for shareholders after the managers’ use of the cash generated to pay for items of expenditure to maintain the strength of the economic franchise (e.g. additional capital items, additional working capital, marketing spend, R&D and staff training) and to maintain unit volume and to invest in all value-generating projects available.

Depending on circumstances, the owner earnings figure may be the same for every future year or on a steadily rising (or falling) trend.

Naturally, owner earnings are impossible to obtain with any degree of precision because many of the input numbers are merely educated guesses about the future.  Despite this imprecision it remains an important method for thinking through valuations.

Owner earnings analysis is about future cash available for shareholders to take out of the business.  But the only evidence we have available is past data.  We start with that, and then use qualitative analysis to judge whether to simply project forward the past pattern or modify the previous trend for future orientated thinking.

In the following we use what the company actually invested in new working capital items and in new fixed capital items, and what they spent on marketing, R&D and staff training etc. already deducted from the P&L.

What the analysis really requires is the amount necessary to maintain the quality of the economic franchise, unit volume and invest in value generating projects.  To start with we make the bold assumption that what was spent by the managers was also the necessary amount.

When we move to forward-looking analysis to value the firm we need to make another bold assumption on the real amount needed to invest in new WC, fixed capital items, etc., in the future.  The historical analysis helps us make that judgment

£m        YEAR 2013   2014   2015
Profit after interest and tax deduction (before exceptional items) 79 76 59
Add back non-cash items such as depreciation, goodwill and other amortisation

 

19 20 23
Totals to: Amount available for distribution to shareholders before considering the need to spend on fixed capital items and working capital items to maintain the company’s economic franchise, unit volume and invest in value generating projects. 98 96 82
Deduct fixed capital and working capital investment. (The figures shown are actual expenditures and are therefore a rough proxy for the ‘needed’ expenditures to maintain franchise, etc.)

 

-41 -88 -69
Owner earnings 57 8 13
£m              YEAR 2016   2017   2018   2019
Profit after interest and tax deduction (excluding gains on property) 68 65 59 64
Add back non-cash items such as depreciation, goodwill and other amortisation 25 28 28 30
Totals to: Amount available for distribution to shareholders before considering the need to spend on fixed capital items and working capital items to maintain the company’s economic franchise, unit volume and invest in value generating projects.

 

93 93 87 94
Deduct fixed capital and working capital investment. (The figures shown are actual expenditures and are therefore a rough proxy for the ‘needed’ expenditures to maintain franchise, etc.)

 

-76 -68 -79 -44
Owner earnings 17 25 8 50
 

Average owner earnings is £25m over seven years if we accept the actual expenditure on PPE and WC over these seven years represents the necessary expenditure to maintain franchise and unit volume.

Before I accept the historical numbers I need to make allowance for the exceptional items that managers like to write off – see earlier newsletter where I reckon we should allow for a £9m………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1

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