In 1986, Warren Buffett detailed his valuation method. He stated that the value of a company is simply the total of the net cash flows (owner earnings) expected to occur over the life of the business, discounted by an appropriate interest rate. He defined owner earnings as follows:

“These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less (c) 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….Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes…All of this points up the absurdity of the ‘cash flow‘ numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) – but do not subtract (c).”

The objective of this post is to discuss the conundrum of valuing a company when there is a significant difference between reported accounting profits and Owner’s earnings . The first company is Dish TV. I first remember coming across the Cable TV business model reading this excellent biography of John Malone, For 20-25 years, which Malone served as TCI( Tele-communications Inc, a Cable giant in US), company hardly reported any accounting profits, taking advantage of allowed accelerated depreciation under US tax laws, but inarguably was a huge wealth creator (From his debut in 1973 until 1998 when the company was sold to AT& T, the compound return to TCI’s shareholders was a phenomenal 30.3 percent, compared with 20.4 percent for other publicly traded cable companies and 14.3 percent for the S& P 500 over the same period.A dollar invested with TCI at the beginning of the Malone era was worth over $ 900 by mid-1998).

One primary reason was the strong cash flows of the company which Malone used brilliantly to acquire assets all around the country and gain leadership position. In a recent discussion, i had with a fellow investor on twitter , we talked about similar strategy adopted by DTH players in India , frontload depreciation and no taxes. Dish TV hardly posts any accounting profits but has already started generating FCF from last year. And, analysts expect it to post FCF of ~100 crs this fiscal year.

The second company is Tata communications This company is in a turnaround phase and most likely will report accounting profits in future, but a closer look at robust cashflow numbers and management guidance about mantainence capex will tell you that this company already on a steady path.

Finally, i would like to add AMAZON, ( the retail giant we all know about ) Amazon’s management has always stated their goal is to maximize free cash flow per share , and even after having negligible profits for past few years , it has been able to grow relentlessly. Although, Amazon differs from former two examples on two fronts,lack of operating profits and a float(owing to its negative cash conversion cycle) .

Yes the market pays for multiples of accounting profits but may be, one of the ways to make good returns is buying before the story gets apparent in the numbers. Its easy to figure out the conventional wisdom on surface from the numbers, but its always better to delve deeper and weigh the underlying qualitative aspects.