Warren Buffett presents two income statements for nineteen eighty-six. One reports about forty million dollars of profit; the other, less than twenty-nine million. They describe the same business: Scott Fetzer. The first shows what its accounts would have looked like without Berkshire's purchase. The second reflects the acquisition. Revenue, wages, and operations are unchanged.
The difference matters to anyone hoping to spend the profits. Owners can take out what remains after paying real economic costs, providing for obligations, and keeping the business competitive and financially sound. Buffett calls the resulting estimate owner earnings. Neither income statement supplies it without some work.
What the business must keep
Berkshire's purchase raised the recorded values of Scott Fetzer's inventory and other assets. Those values then produced larger charges against profit. The business hadn't suddenly begun consuming more resources because its owner changed. Bookkeeping recorded the purchase; an investor still had to establish what the operation could earn.
Buffett starts with reported profit and adds back appropriate noncash charges, including depreciation and amortization. Then he subtracts the average capital spending needed to preserve the business's competitive position and operating volume. He also subtracts any additional working capital needed for that purpose, including extra money tied up in inventory or customers' unpaid bills. Only the required increase belongs in that deduction. The entire existing working-capital balance does not get deducted again.
Both halves matter. Adding depreciation back reverses an accounting allocation. The machinery still wears out. Subtracting necessary reinvestment allows for keeping it productive. In Scott Fetzer's case, the adjustments brought both statements to the same amount before reinvestment. Since the operation was identical, its needs were identical too. Buffett's estimate of owner earnings was about forty million dollars under either presentation.
That favorable result is no shortcut for other businesses. Some must spend more than depreciation merely to hold their ground. A year with little spending may mean that replacement has been postponed. An average over several years is more useful, though it still requires judgment. Establish what the existing operation needs before treating expansion as an optional use of surplus cash.
The type of charge matters too. Accounting goodwill records the acquisition price left after valuing identifiable net assets. Economic goodwill comes from a business's ability to earn unusually high returns on its tangible capital. That strength can persist, grow, or deteriorate. The historical practice of steadily amortizing goodwill didn't establish that it was wearing out. Physical equipment does wear out. Dismissing both charges simply because neither requires cash today can badly overstate what owners may withdraw.
Bills that haven't arrived
Cash can stay in a company's bank account while its owners incur a real cost. An employee stock option gives its recipient a valuable claim at shareholders' expense. No cash has to leave the company for that transfer to cost owners something. Valuing the option requires an estimate; uncertainty doesn't make its cost zero. Recognizing the expense leaves the company free to use options when they make sense.
Managers can also move costs around. Loading expenses from several periods into one already bad quarter makes later periods look cleaner. Inflating liabilities when acquiring a company, then releasing the excess into income, can manufacture a recovery without improving operations. A promise of smoothly rising earnings gives managers a reason to try. An owner needs to understand what changed, beyond the number's reassuring direction.
Pension assumptions offer another route. Assume the pension fund will earn more on its investments, and the expense charged against current profit can fall. Neither the fund's assets nor the benefits owed improve because someone raised that estimate. Buffett tests such expectations against the investments held and the returns they would have to earn. Optimism in the accounts cannot finance a pension payment.
Retiree medical benefits expose the danger of waiting for a cash bill. When employees earn a promise of future coverage, the company acquires an obligation. Its present value belongs in the assessment of current profit and net worth. Counting only today's payments hides the accumulating cost. With uncapped coverage, longer lives and rising medical costs can make the eventual burden much larger. Distributing money while ignoring that promise leaves less available when employees need it.
Earnings you haven't received
Careful interpretation can also reveal earnings missing from the headline. A company you partly own may retain profits that don't appear in your reported income. To reported operating earnings, Buffett's look-through calculation adds the owner's share of those retained earnings, then subtracts the tax a distribution would have triggered. Their value depends on how well the business uses them. They help explain underlying earning power; they are not cash already received and available to spend.
Large groups need examination business by business. Combining unlike operations in one total can hide their different needs and prospects. Useful segment information lets owners judge those differences instead of assuming every dollar of reported earnings has the same economic meaning.
A useful report therefore supports judgments about business value, obligations, and management's performance. It cannot remove the estimates. Buffett expects enough explanation to test them. Before trusting a rising profit, an owner should be able to account for the spending that keeps the business healthy and the claims that remain after the reporting period ends.
Three things to keep
Subtract necessary reinvestment, including added working capital, before treating profit as owner cash.
Costs remain real when paid through shares or promised for later.
Retained investee earnings can build value without becoming cash you can spend.