This post is too long. I will highlight a few things at the top as a sort of summary:
- Owner’s Earnings is the best number to focus on when valuing a business.
- We often use shortcuts that are horrible measures of value (comparable valuation, Bull Shit Earnings metrics, including, but not limited, Ebitda and suffer often from Anchoring Bias when stock prices decline dramatically).
- Highlighting these bias in your own work may be helpful.
- Rollercoaster investments are the least attractive candidates for your portfolio because you need to buy and sell at the right time and you are constantly turning over your portfolio, resulting in increased risk of mistakes.
What’s a Business Worth?
“A business is worth the discounted value of all the future cash flows a business owner can pull out of the business (“owners earnings”) from now until judgment day.” Buffett
This sounds so simplistic and we can argue about when judgment day (I am hoping for later) is going to happen or what the proper discount rate is to use, depending on how risky the business is, but the key focus should be on coming up with an accurate description of owners earnings.
Owners earnings is one of the key Buffett-coined phrases that does not get enough play in today’s financial world. I don’t think most people like to use it because it forces the business to really drill down and figure out how much excess capital the company is actually producing.
Let’s take a simplistic example. Imagine you sell snow cones (it’s currently hot here in Utah where I live). Each year you sell 1,000 snow cones for $1 a piece. You have food and labor expenses of $800, so your net profit is $200 per year. However, the snow cone machines are expensive and wear out after 3,000 snow cones. Furthermore, a replacement snow cone machine costs $600. Using these figures, your owners earnings are approximately Zero, thus valuing your business at approximately $0. Executives at Snow Cone Inc. might want to explain that the new snow cone machine will almost certainly last longer than three years this time and will produce even higher quality snow cones, thus allowing you to charge $1.10 per snow cone, however, I would be skeptical. Part of the $800 in expenses is their compensation and even if a business produces zero owners earnings, most business are able to cover the executive compensation (funny how that seems to work out).
I like to keep examples simple because we can test out how stupid we can become when we needlessly complicate things. Although it seems obvious that owners earnings should be the focus, I want to discuss some often used “substitutes” that are very poor shortcuts to proper valuations.
Now, let’s move to complicate this a little bit.
Imagine there was a market where we could buy and sell different snow cone businesses. Sally’s Snow Cone Business could be bought and sold, Mark’s Snow Cone Business, etc. (I am sure Sally and Mark would come up with better names).
One day, Sally’s is “trading” for 8x Ebitda and Mark’s is trading for 7x Ebitda (earnings before interest, taxes, depreciation and amortirization). This might lead some smart investor to conclude that Sally’s business is undervalued compared to Mark’s. One could therefore profit if one bought Sally’s stock and shorted Mark’s.
This example uses two deceptively common practices that pervade the investment community today. First, the focus on comparable valuations. I just don’t get this. Businesses are so unique in their various markets, business strategies, specific assets, cultures, management, etc. I can’t think of any situation where I thought it was helpful to compare valuations across different companies to give me even a rough estimate of value. It’s like we have all turned into real estate agents. It’s actually pretty impressive how deep this metric has seeped into Wall Street culture today.
Ebitda vs Owners Earnings:
Getting back to owners earnings and the Snow Cone businesses, the comparables metric almost always uses some made up replacement for owners earnings, in this case, Ebitda.
Munger has said: “Whenever I see Ebitda, I just substitute, Bull Shit Earnings.”
This metric, Ebitda, further removes us from our ability to judge the actual owners earnings of a business. The example above discusses why owners earnings is a better metric than Ebitda because Ebitda is typically used to obfuscate required capital expenditures to maintain the viability of the business.
If Sally’s Snow Cone business was trading for $20 per share in 2016, but in early 2017 was selling for the bargain basement price of $10 per share, some investors might think they are getting a deal. Why? Well, it’s 50% off, right?
The force of anchoring bias in investing is strong. We want to buy bargains, so we tend to look at companies where the stock prices have fallen significantly. However, if we believe that the market is somewhat inefficient and we can buy companies at prices below their intrinsic value, it stands to reason that there are companies currently trading for prices above their intrinsic value, i.e. trading for more than they are worth. If the latter is the case, the decline in the stock price of a company could merely mean that it was previously overvalued and after its subsequent decline is now fairly valued.
In summary, we often use substitute metrics to do the hard work of valuing a company. Comparables, Bull Shit Earnings Metrics, and Anchoring Bias are all “valuation techniques” that miss the true concept of owners earnings.
I highlight these examples because a current and small investment of my own may suffer from some (or maybe all) of these problems.
I recently bought a small position in AMC Theaters.
- AMC is down approximately 38% ytd vs. roughly flat performance from its two main competitors, Regal and Cinemark. (Healthy use comparables and anchoring bias all rolled into one).
- AMC trades at a slight discount, on various Bull Shit Earnings Metrics, to its competitors Cinemark and Regal. (You need to account for NOLs, AMC’s NCMI stake and its European division to get at this multiple discount). (Very heavy on the comparable valuation on this assertion).
The major factor the 2016 BS Earnings number for me is the depreciation. Theaters get old. The screens wear out, the sound system starts to break, the seats become uncomfortable, etc. I can live with the idea that AMC is projecting roughly $900m in pre-capital expenditures owner’s earnings (owner’s earnings in this case would also include lenders, i.e. interest payments). Their rough figure for maintenance capex is around $150-200m. However, their depreciation figure is around $475m for 2016. That’s a wide gap. Furthermore, AMC’s capital expenditures in 2016 were roughly $420m
This leads me to question how much of AMC’s capital expenditures is growth capex vs. maintenance capex. To give you an example, imagine you decide to “upgrade” the seats at a bunch of your theaters. Some of these theaters almost certainly had fairly old seats that needed some sort of replacement, i.e. maintenance capex. However, if you push the message that you are upgrading all of your seats, then the incremental dollar you are spending on the seat upgrades can be classified as “growth capex.” Of the roughly $420m in capital expenditures AMC spent last year, it is tough to pinpoint with certainty how much of that amount was growth vs. maintenance capex.
AMC’s financials are messy. They have acquired three fairly large theater companies in the past 9 months and roughly doubled their size (going from 5,426 screens to 11,225 screens). They are in a “upgrade” phase, which certainly contains some part growth and some part maintenance capex. It’s tough to get a clear indication what the normalized owners earnings are in the near term, however, over the next 12 months, I think the movie industry in general will remain fairly stable after the upgrade phase of AMC capex is done, there will be sufficient free cash flow to delever and/or buy back stock at attractive prices.
If AMC’s true owner’s earnings is around $700m, and I think that is worth about 12x, the entire enterprise valued would be around $8.4B, however, the current value is roughly $7.2B. On paper, this appears to be only a 16% upside from current valuation, but given the debt carried by AMC (approximately $4.6B), the $1.2B valuation increase would accrue to the equity, which is only worth around $2.6B right now, thus offering a 45% upside.
If you are keeping a scorecard on all the assumptions here, the owners earnings number is one that I am poking at with a stick. It’s not exact. The 12x figure I cite is also a rough number based on the stability of the business. Combining multiple different rough estimates makes investing very much an art. This is why it is important to maintain a large margin of safety, between what you think the company is worth and the price you have to pay.
The final thought on AMC is that it falls into what I would call the roller coaster bucket of investing (this point deserves it’s own post). I see it as a fairly stable business, but one that will not significantly compound value over the long-term because the economics of the business do not lend itself to such compounding. However, you can make money if you are able to buy it when it is undervalued and sell it when it is fairly valued. The downside of this bucket is clearly that you will have to turnover your portfolio components each time a company becomes fairly valued.
Disclosure: Clients of The Sova Group own shares in AMC.