 Good day, fellow investors! One of the best ways to analyze a business, to see whether it is an investment for you or not, are to use Buffett's owner's earnings and he explained his tactics when it comes to analyzing businesses in his 1986 letter to shareholders. A long time has passed since some accounting things have changed, but we are going to explain in details using Netflix and Apple as an example. We're going to explain owner's earnings and you'll see how whenever you analyze a company, whenever you look at potential investment, this will come in handy. Before we start with the details of accounting, the best way to teach something is to use storytelling and a great story came to my mind while I was thinking about this video. This weekend we were in Gratz, which is a city in Austria and we were visiting just a small family vacation and we were sleeping at Hotel Park in Gratz, which is a traditional hotel there and it is owned and managed by the fourth generation. So it is a family hotel and little Paulina was born in 2016 and she'll be the fifth generation managing the hotel and when you have such a hotel where the family is the owner, do they care about the valuation of the hotel, the stock price when you look at businesses? Do they care about EBITDA? Do they care about their credit ratings by the ratings agency? Do they care about how the market will do in the next year? Will there be a recession or not? Do they care about I don't know what else is going on with the trade war or they just care about something else? Well, they care about what is the amount of money they can take out from the hotel after all the expenses are paid. That is what they really care about and then when they have that available money they want to see okay can we invest in growth, can we do some changes in the hotel or can we just take it out pay ourselves some dividends and leave off the property that we own. Just one note here if all the other hotels in Graz decide to build a roof pool or something like that then the hotel where we stayed should build the same pool and that's not growth that is an investment just to keep its market share and that's something very important when it comes to capital expenditures that we'll explain in a moment. So when it comes to investing in businesses you have to see okay what can I take out from that business year over year over year or reinvest in growth. So when it comes to businesses you have to look okay what can I take out from the business and then I am going to decide whether to reinvest in growth or pay myself a dividend. Those are owners earnings and that is what Buffett has always been focused on when invest what are the owners earnings. Alongside growth and other things but let's focus on the accounting here let's explain it in details let's define it and let's use Netflix and Apple which are very very interesting examples. To define owner's earnings Buffett defines owner's earnings from the letter as following owner's earnings these represent reported earnings plus depreciation depletion amortization and certain other non-cash charges such as company and items one and four less 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 the average annual amount of capitalized expenditures in C. However businesses following the lethal inventory method usually do not require additional working capital if unit volume does not change. So this is a lot let me simplify the above and then define the account. So owners earnings are reported earnings plus depreciation depletion amortization other non-cash charges like impairments for example minus the average annual capex amount that is needed to fully maintain the long-term competitive position and unit volume of the business minus working capital changes. If those changes are negative then minus and minus gives a plus. Let's define reported earnings. You can find reported earnings at the bottom of the income statement earnings are what the company makes after deducting all the accounting expenses from revenues. In this case Netflix for 2018 had net income of 1.2 billion dollars. So that's the net income and we'll use it to compare and to see what is the actual owners earnings for Netflix. The next step is to calculate depreciation depletion and amortization and actually add it to owners earnings. What's the deal with depreciation and amortization? When you invest into something over the long term you take lump sum of money and you invest it let's say in a building in an office. The thing is that to incentivize investments one thing has been invented which is amortization and depreciation. If you invest in a building it usually doesn't lose value over the next 40 years but you can charge that your investment you can charge the expense over the next 20 to 50 years depending on the building and the accounting rules. So let's say you buy an office building and you can depreciate it by 25 years or 4% per year. So if you invested a million 40% would be an expense to the income statement but not a cash expense. So you would have that cash leftover on that expense you didn't pay taxes. So businesses are incentivized to invest and improve the economy through amortization and depreciation plus they pay less taxes over the long term. So you invest and with depreciation it allows you to get your money back and that's why Warren and Buffett adds it to net income. So you can find depreciation amortization and other non-cash charges in the cash flow statement. Here I have marked it in yellow and we can see that amortization of streaming content assets was 7.5 billion in 2018 amortization of DVD content assets 41 million 83 million depreciation amortization of property equipment and intangibles. Something that I've marked here in pink are stock-based compensation expenses. Some immediately add those two to the calculation but I would avoid that as stock-based compensation expense is an actual expense that dilutes shareholders in the long term and it's the same if you give stocks and then repurchase them or simply give money to managers or whoever gets those share-based compensations. So I want to use them I won't add them to net income as some might do so it's up to you to pick what is that is it an expense or not. Non-cash charges the other account mentioned by Buffett includes stock-based compensation and other non-cash items. Other non-cash items include the third income tax write-downs in the value of acquired companies which is what Buffett discusses. However Wall Street has quickly added stock-based compensation as a non-expense due to the non-cash form but as I said I see it as an expense. In any case net income from Netflix 1.2 billion we add the amortization of streaming content assets amortization of DVD content assets depreciation and amortization of property stock-based compensation expense that's how you will find it some textbooks other non-cash items and we are at 8.9 billion of owners earnings sounds much better than 1.2 billion but now we have to account for the average annual capital expenditures that are needed to fully maintain the long-term competitive position and unit volume of the business. So capital expenditures there are two types of capital expenditures expenditures for growth and expenditures that maintain the business as is maintain it maintain its competitive position does the status quo to keep the business rate running what's necessary to invest to just keep the business running as is so the biggest expense for Netflix is content and they have to acquire it and for me it's not an investment in growth because they scale on the number of users but it's not that if they buy more content they get more users so it's actually not growth it's just their business they have to acquire content so it's an investment necessary to maintain its competitive position and here we can see in the green lines 13 billion spent in 2018 to acquire streaming content there are some other investing activities like DVD content assets 38 million property plant and equipment 173 million and other changes in assets 126 million depending what it was so when we deduct 13 billion from the previous owners earnings that we received by adding the amortization and depreciation of 8.9 billion we get to owners earnings of negative 4.2 billion that's already a big difference when compared to 1.2 billion reported in net income but we still have to account for possible changes in working capital working capital is defined as the difference between a company's current assets and current liabilities working capital is a measure of a company's short-term liquidity or its ability to cover short-term liabilities we can calculate the working capital from the current asset and current liabilities accounts on the balance sheet so Netflix's total current assets 2018 9.6 billion total current liabilities 6.4 billion compared to 2017 and the respective increase in working capital is 1 billion that has to be again deducted from the business and the owners earnings because they need to put 1 billion more into the business to keep it as is and we are now at negative owners earnings of 5.2 billion practically from Buffett's perspective Netflix is losing 5.2 billion per year for its owners and if you look at the balance sheet you can see total liabilities increased by 5.3 billion from 2017 to the end of 2018 which is exactly the loss they made for their owners so this is what Buffett focuses on and what made him what he is today now you might wonder why does Netflix have 120 billion market capitalization when they lose 5 billion 5.5 billion per year for their owners where here it's a game of growth Netflix is a growth company and if they can keep the content costs stable at 13 billion but grow continue to grow at 26% as they have been doing in the past over the next three years the revenue will double but their content that they can scale on a global level would remain the same so from losses now 5.5 billion down if they double revenue if they bring it to 40 billion pay 20% on taxes on the difference with the same costs then they would add 16 billion of profits on that 16 billion minus the 5.5 they are losing now that's 11 billion of owners earnings on a 20 120 billion market cap that's a bargain especially if they continue to grow like this over the long term so this is the game with Netflix not the current owners earnings which is usually something Buffett is focusing on but the potential future owners earnings thanks to the scalability of their business with keeping costs fixed if they can keep the cost fixed then an increased revenue then it will be a profitable business for owners until they don't they manage to do that then it will be a losing business for owners let's do another example where Buffett owns a significant stake Apple as we used for Netflix I'm going to do the same with Apple and use 2018 as the numbers net income for 2018 was 59.5 billion we have to add depreciation depletion amortization other non-cash charges to the above net income from the cash flow and we have to make a small adjustment again always such adjustments with all companies Apple had a lot of profits abroad if they would repatriate that that would hit severely their taxes but as the tax went down in 2018 they made a lot of deferred taxes benefits and liabilities in their accounts for the future so that is something I'm going to avoid talking here so that it doesn't confuse you so let's focus on the depreciation and amortization of 10.9 billion add that to the 59.5 billion and we get to 70.4 billion on capital expenditures Apple is spending around 13 billion per year we can also find that in the cash flow statement we can estimate that it is all to stay in business money as the acquisition some account amounts to only 721 million per year we deduct 13 billion from 70 billion and we get to 57 billion of owners earnings per year we still have to adjust for working capital and when we calculate the working capital again that's an adjustment here marketable securities with Apple the second yellow line here is not something they use in their businesses just they cash they have stashed so I'm going to not account for that when I account for all the other current assets and liabilities you can see that 2018 and 2017 there was negative working capital of 26 billion so there was no change so we don't have to account for that with Apple's owners earnings if you wonder how can there be negative working capital well Apple's business is financed by its suppliers when you buy a phone you buy it immediately when they pay their suppliers they pay later they have some debt short-term debt which means that they are financing their business their working capital with debt and suppliers that's a great business model shareholders don't have to put up the money and Apple can distribute do buybacks that it usually does and reward shareholders in that way so I hope I have explained well what owners earnings are the conclusion is that okay Buffett uses them so it's always interesting to check what are the real on owners earnings compare it to the growth and the real story compare it also to the accounting earnings as we have seen a big difference with Netflix and it will give you a better understanding of what the business actually is that is what owners earnings are crucial they are crucial for investing especially when you start thinking about what will be the owners earnings in the future depending on the what the company is doing now and the possibility of the company with high growth companies like Netflix it's a little bit difficult to see what's the real value there because we don't know what will be the growth rate in the future the growth rate of the costs or perhaps even the decline in the costs of content it will be something very interesting to follow but when you can make models using earnings owners earnings like Buffett did on a business then you know the business really well and then you can estimate whether it is undervalued or overvalued in relation to your investment thesis and requirements this is what I do all the time I try to find okay what are the benefits that the business will bring to me as a shareholder over the long term when I can figure that out from the accounting and everything and when I see that it offers me a high yield from the business then that is something that I like buying so looking forward to comments thank you for watching don't forget to subscribe smash that like button and comment ask questions send me an email check my website for my research if you want to read my research reports so check my website and I'll see you in the next video