Investing Guidelines: Financial Tenets 113Graham had reduced the company’s debt by 70 percent. In 1983, long-
term debt to equity was a low 2.7 percent—one-tenth the newspaper
group average—yet the Post generated a return on equity 10 percent
higher than these same companies.
“OWNER EARNINGS”
Investors, Buffett warns, should be aware that accounting earnings per
share represent the starting point for determining the economic value of
a business, not the ending point. “The f irst point to understand,” he says,
“is that not all earnings are created equal.”^4 Companies with high assets
to prof its, he points out, tend to report ersatz earnings. Because inf lation
extracts a toll on asset-heavy businesses, the earnings of these businesses
take on a miragelike quality. Hence, accounting earnings are useful to the
analyst only if they approximate the expected cash f low of the company.
But even cash f low, Buffett warns, is not a perfect tool for measur-
ing value; often it misleads investors. Cash f low is an appropriate way
to measure businesses that have large investments in the beginning and
smaller outlays later on, such as real estate, gas f ields, and cable com-
panies. On the other hand, companies that require ongoing capital ex-
penditures, such as manufacturers, are not accurately valued using only
cash f low.
A company’s cash f low is customarily def ined as net income after
taxes plus depreciation, depletion, amortization, and other noncash
charges. The problem with this def inition, Buffett explains, is that it
leaves out a critical economic fact: capital expenditures. How much of
the year’s earnings must the company use for new equipment, plant up-
grades, and other improvements to maintain its economic position and
unit volume? According to Buffett, approximately 95 percent of U.S.
businesses require capital expenditures that are roughly equal to their
depreciation rates. You can defer capital expenditures for a year or so, he
says, but if over a long period, you don’t make the necessary improve-
ments, your business will surely decline. These capital expenditures are
as much an expense to a company as are labor and utility costs.
Popularity of cash-f low numbers heightened during the leveraged
buyout period of the 1980s because the exorbitant prices paid for busi-
nesses were justif ied by a company’s cash f low. Buffett believes that
cash-f low numbers “are frequently used by marketers of business and