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In Buffett’s 2016 letter to shareholders he draws his shareholder’s attention to the distinction between “earnings power” and reported accounting earnings. He states
“What We Hope to Accomplish: Charlie Munger, Berkshire’s Vice Chairman and my partner, and I expect Berkshire’s normalized earning power per share to increase every year. Actual earnings, of course, will sometimes decline because of periodic weakness in the U.S. economy.”
Normalised earnings power is a concept developed by Buffett’s mentor, Benjamin Graham.
It is very difficult to establish with any great precision. Examining past earnings (the average, trend growth, or decline) is of some use, but there must be good grounds for believing the trend to be a guide to the future if simple extrapolation is to be used.
Despite the inability to be precise about earnings power, having a firm intellectual grip on the earnings power range, and the logic steps behind arriving at that range, is crucial for value investors.
A precise number is not necessary. What is necessary is to go through a thought-process that takes into account the main factors.
Live with imprecision
Even after going through a rigorous process the range of the earnings power can seem to outsiders to be remarkably wide. Thus, as a value investor, you might very well estimate earnings power to be somewhere between £1m per year and £4m per year. Admittedly, the range will usually be much tighter, but would still shock a conventional analyst brought up on the Chartered Financial Analyst curriculum.
Enough or not enough? – that is all you need to know
What matters is whether you can confidently state that the earnings power is sufficient to justify the current share price.
In many cases you cannot determine that. Perhaps this because the range is so broad that in some parts of the range the current share price looks low, but relative to other part of the earnings power range the share is high.
But there will be a few cases where even at the lowest boundary of the earnings power range the discounted present value of that earnings power, i.e. intrinsic value, is significantly above the current share price,.
Then you have margin of safety built in.
What goes into the analysis when thinking about earnings power?
Firstly, it is a long-term concept.
Buffett refers to “normalised” earnings power; thus, for example, you do not change your long-term estimate of earnings power at different points in the business cycle, or if the firm get hit by a temporary problem.
It depends on a fantastic range of factors, but the main ones boil down to:
•The economics of the industry, and the degree of competitive advantage held by the company.
•The competence and integrity of the managers
•The operational and financial stability of the company
These are all fuzzy elements. But we need to get used to the idea that the most important aspects of a business are not the hard numbers but the fuzzy aspects (e.g. the psychology behind customers paying three times the price for a fancy tonic water rather than an older brand, or the brilliance of the Dyson team of engineers and spirit of innovation).
It is not that numbers are unimportant. It is that the numbers are inputs to gaining insight into the really crucial analysis, which is qualitative.
A coming together
Over the long run earnings power will be reflected in actual accounting earnings (at least approximately).
But over the short run the two can differ markedly because they are drawn from different conceptual bases.
Why might Buffett expect an “increase every year”
Some possibilities:……………………………To read the rest of this article, and more like it, subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
