With owner earnings we are trying to obtain the earnings that, in future, would be left for shareholders after the managers’ use of the cash generated to pay for items of expenditure to maintain the strength of the economic franchise (e.g. additional capital items, additional working capital, marketing spend, R&D and staff training) and to maintain unit volume and to invest in all value-generating projects available.
Depending on circumstances, the owner earnings figure may be the same for every future year or on a steadily rising (or falling) trend.
Naturally, owner earnings are impossible to obtain with any degree of precision because many of the input numbers are merely educated guesses about the future. Despite this imprecision it remains an important method for thinking through valuations.
Using the past to guess the future
Owner earnings analysis is about future cash available for shareholders to take out of the business. But the only evidence we have available is past data. We start with that, and then use qualitative analysis to judge whether to simply project forward the past pattern or modify the previous trend for future orientated thinking.
In the following we use what the company actually invested in new working capital items and in new fixed capital items, and what they spent on marketing, R&D and staff training etc. already deducted from the P&L.
What the analysis really requires is the amount necessary to maintain the quality of the economic franchise, unit volume and invest in value generating projects. To start with we make the bold assumption that what was spent by the managers was also the necessary amount.
When we move to forward-looking analysis to value the firm we need to make another bold assumption on the real amount needed to invest in new WC, fixed capital items, etc., in the future. The historical analysis helps us make that judgment.
“Owner earnings” in the past...
P“Owner earnings” in the past
Profit after interest and tax deduction
Add back non-cash items such as depreciation, goodwill and other amortisation
Totals to: Amount available for distribution to shareholders before considering the need to spend on fixed capital items to maintain the company’s economic franchise, unit volume and invest in value generating projects.
Deduct fixed capital expenditure other than property. And deduct cash invested in working capital. (The figures shown are actual expenditures and are therefore a rough proxy for the ‘needed’ expenditures to maintain franchise, etc.). A positive number indicates cash being released from WC changes greater than cash used in capex.
Past years have produced a surplus after paying for working capital additions/reductions and capex items which have been volatile. The large variation is mostly due to jumps up and down in inventory levels during the Covid period.
Because of that volatility from one year to the next and the volatility of profit after tax we need to obtain a longer run estimate of past “owner earnings” by taking an average. This turns out to be £54.4m pa over the six year period.
If we took this number as our estimate for each future year, i.e. no growth, then we can discount (at 8%) all those future owner earnings to obtain an estimate of intrinsic value: £54.4m/0.08 = £680m or £3.11 per share. This compares well with the current share price of around £1.70.
Will the future be like the past? Now, more than ever, we are uncertain, but we can think in terms of reasonable scenarios.
Scenario 1: Recession and recovery
Owner earnings fall to zero for two years. All years after that generate £54.4m in owner earnings (I see no reason to believe that Halford’s reputation will be destroyed nor for the market for bicycles and car parts & services disappear).
What is the discounted value of those owner earnings, i.e. our estimate of intrinsic value?
Value of a perpetuity: £54.4m/0.08 =£680m
This needs to be discounted by two years: Intrinsic value estimate is £680m/(1.08 x 1.08) = £583m or £2.66 per share.
Under this scenario the shares offer a good margin of safety.
Scenario 2: Depression
The depression lasts for 5 years and Halfords’s annual profits average zero over those five years. In the sixth year they bounce back to the average of the six years 2017 – 2022:
Intrinsic value estimate: Perpetuity value = £680m
Discounted over five years at 8% pa: £463m, or 211p per share
There is still some margin of safety on the current market price.
Scenario 3: Recession and growth
Two years of zero profits followed by a year at £54.4m which then grows each subsequent year by 3%.
£54.4m/(0.08 – 0.03) = £1,088m
Then discount by two years: £1,088m/(1.08 x 1.08) = £933m or £4.26 per share.
All in all, intrinsic value estimates based on owner earnings suggest that Halfords’ shares are cheap on the stock market.
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