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Warren Buffett regretted in 2019 for making the wrong call in not buying Alphabet Inc. ( GOOG ) (NASDAQ: GOOGL ). He regrets not buying even though GOOG fits all the traits that he looks for in a perpetual compounder – the wide moat, the toll-status in the economic eco-system, and incredibly high return on capital employed. You will see that these reasons for his regret are still valid now.
Furthermore, GOOG does not only enjoy high returns on capital but also can always find plenty of opportunities to reinvest large amounts of additional capital as you will see in this analysis. In Buffett’s own words: Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. Finally note that even for such high-power compounders, Buffett did not forget to empathize that you should not “leave the question of price aside”. And this article will show you GOOG earnings more than what’s on the surface. Its true economic or owners’ earnings have been consistently better than its accounting earnings. With the recent sell-off, its valuation has become close to what I call the Buffett value-line. GOOG’s accounting EPS and owners’ earnings
The commonly quoted PE for GOOG is based on the GAAP accounting earnings (about 25x as of this writing), which do not reflect its true economic earning power. And in GOOG’s case, the accounting earnings underestimate its true earning power by a sizable margin.
The next chart shows the GAAP EPS per share, free cash flow (“FCF”) per share, and owners’ earnings (“OE”) per share for GOOG over the past few years. And you can see that FCF has been either very close or higher than EPS, which already shows a sign of the discrepancy between the GAAP EPS and the OE. And remember that FCF already underestimates the true OE because ALL CAPEX expenses have been considered a cost in calculation FCF. However, only the maintenance CAPEX should be considered as a cost. And the owners’ earnings should be free cash flow plus the portion of CAPEX that is used to fuel the growth (i.e., the growth CAPEX). As a result, the OE is even higher, as shown by the orange bars.
And we will see how the OE is analyzed in detail next. Author and Seeking Alpha data. GOOG’s growth CAPEX and owners’ earnings
The key to analyzing the OE is to delineate the growth CAPEX from maintenance CAPEX. And the reason that the growth CAPEX should not be considered a cost is that it is OPTIONAL. This is a key insight that investors like Buffett have been promoting for decades. And probably the following comment from Buffett himself again explains it best (and the emphasis are added by me): 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). However, estimating (C) is indeed difficult and involves a more advanced understanding and analysis of the financial statements. The basic concepts and steps are detailed in my earlier article on AAPL . And here a very brief summary is provided to facilitate the rest of this discussion: The CAPEX expenses for a business are the sum of two parts: the maintenance CAPEX and growth CAPEX. Maintenance CAPEX is part c that Buffet mentioned above. It is the mandatory part and the growth part is the optional part. The growth part should be considered part of the owners’ earnings because it can be returned to the owners if the owners decide not to grow the business anymore – again, a key insight that investors like Buffett have recognized.
Dissecting the maintenance CAPEX and growth CAPEX is, therefore, crucial to understanding the true economic earnings. However, as mentioned by Buffett, the […]
source Alphabet: Why Warren Buffett Regretted And Why He Should Take Another Look Now
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