The Individual in the Crowd

The Individual in the Crowd

The Individual in the Crowd

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THE INTEGRATIVE TENDENCY

We can now look at the crowd phenomenon from the individual’s point of view because it follows that, if a crowd is to form, individual members must, in some sense, ‘want’ to join and be willing to conform to behavioural standards imposed by others. No group – and especially not a crowd – can exist unless each group member alters their behaviour to conform to the will of the majority. In other words, there must be a basis for the integrative tendency, or the tendency to devote oneself to a group.

Theoretically, we can observe three aspects to this phenomenon, namely:

 identification with the crowd;

 acceptance of the crowd’s belief system;

 submission to the authority of a leader.

IDENTIFICATION

There is, indeed, a well-researched predisposition for individuals to reject individuals in other groups, to accept the judgement of the majority in the group to which they belong, and to accept the instructions of a person (or persons) representing authority. In a series of experiments by Henri Tajfel at Bristol University, it was shown that groups of schoolboys aged 14 to 15 could have their behaviour altered merely by telling them that they belonged to a particular group – even an unknown group. Specifically, the schoolboys would automatically associate themselves with other members of the same group, would provide active support for that group and would take every opportunity to disadvantage members of other groups. These phenomena occurred despite the fact that no indication was given to the schoolboys about the purpose or qualities of the groups.

BELIEFS

It seems that uncritical acceptance of group assumptions/beliefs has its foundation in the subconscious need to belong, or not to be seen as different. For example, experiments conducted in 1956 by Solomon Asch at Harvard showed that, when matching the length of a line with one of three other lines, subjects could have their performance measurably altered by group pressures. When asked to match the length of a line with one of three other lines in isolation from others, participants made a mistake less than 1 per cent of the time. However, when placed in a group that had been instructed beforehand to claim that mismatched lines were actually the same, 75 per cent of participants agreed with the majority. This was true even when the actual difference between the lines was very significant. Worryingly, Asch also found that although some participants lacked the nerve to disagree with the majority, some maintained that they had actually seen the mismatched lines as being equal and some doubted their own perceptions.

SELF-AWARENESS AND CONFORMITY ENFORCEMENT

These general conclusions have been confirmed by research conducted at the University of Illinois by Ed Diener. He found that the most important factor in group behaviour was the suppression of self-awareness and, therefore, of self-regulation. In one particular piece of research, Diener compared behaviour under three different laboratory test conditions:

where individuals were self-aware and isolated from group influences;

where individuals were non-self-aware, but were still isolated from group influences; and

where individuals were both non-self-aware and involved in a group environment.

THE CROWD LEADER

Identification with other members of the crowd and an acceptance of the crowd’s belief system is stimulated by each member’s willingness to obey a crowd leader. The importance of a leader for crowd dynamics was Sigmund Freud’s major contribution to the debate, and is based on his idea of a ‘parent substitute’. Specifically, Freud argued that a large group (or crowd) would follow its leader because that leader personified certain ideals and objectives for the group. Group members would essentially disable themselves by projecting their own capacities for thought, decision making and responsibility taking on to the leader.

The crowd leader acts as the main interpreter of new information from the environment, determines the appropriate tactical response and directs strategy. Leaders may be dictatorial or democratic, they may be constructive or destructive, but they will always command the attention of each of the crowd members. However, leadership may manifest in a number of different guises. On the one hand, it may be obvious, in the sense that it is vested in a particular individual or in a subgroup of people (such as a committee or board of directors). On the other hand, it may be covert. It may, for example, be vested in the democratic decision of the group itself or in the shared system of beliefs held by members of the crowd, and the code of conduct it engenders. Covert leadership, however, almost certainly requires some form of ‘totem’ on which the crowd can focus its attention. Throughout history, crowds have been responsive to national flags, figureheads, icons and statues.

THE FINDINGS OF STANLEY MILGRAM

The classic experiment to discover the limit to which people would be obedient to authority was conducted by Dr Stanley Milgram of Yale University. In the experiment, the subjects were ordered to inflict pain on an innocent victim in the interests of an important cause. Authority (or the leader and representative of a group belief system) was represented by a scientist in a white coat who would continually urge the subject to proceed with administering electric shocks to a third person. In fact, there was no electric shock involved at all: the subject did not know it, but the third person (the victim) merely behaved as if there had been one.

At all stages throughout the experiment, the subject was made aware of the effect of their actions, both by a dial on the electric shock machine (which indicated the voltage being administered and the degree of danger involved therewith), and by the screams and protests of the victim strapped into a chair. Milgram found that over 60 per cent of the subjects were prepared to obey instructions to administer the highest and most lethal dose of electricity, even after the victim had given up screaming and was, to all intents and purposes, comatose.

ALTRUISM AND CONFLICT

In the previous chapter, it was noted that the structure of the human brain lends itself to the emergence of non-rational responses to perceived threats of any kind. In particular, the brain stem and the limbic system are subject to a significant stimulus. Significantly, the arousal of these two subsystems at the expense of the neocortex can degrade human behaviour to the extent that some degree of animal- like ‘herd’ behaviour materializes. This is the phenomenon of the crowd.

There are, obviously, different degrees of intensity of crowd behaviour, but its hallmark is non-rational and emotional behaviour, common to a number of individuals acting together. It follows, too, that once a crowd has been catalyzed, the left pre-frontal lobe of the neocortex is even less likely to operate effectively. As a result, the amygdala of each crowd member is given an even freer rein.

The results – as researchers such as Diener and Milgram have verified – can be frightening. A crowd led by a strong leader can be a truly potent force. First, people within a crowd develop a sense of altruism towards other crowd members that is very strong. (Sometimes, indeed, it is so strong that, as Emile Durkheim found, it can result in suicide.) Second, the crowd can achieve objectives using methods that more self-aware individuals would regard as being totally unacceptable. It is not surprising, therefore, that people are more likely to be involved in states of conflict as group members than as individuals. Third, and as a corollary, it follows that conflict (or stress) is a perfect catalyst for the formation of a crowd. If, for some reason, an imbalance develops between two groups, each group member will have common cause with other members of the same group in protecting the autonomy of that group. The paramount need of each group may then release the aggressiveness in, or relax constraints on, each individual.

SPLITTING AND PROJECTION

There is a broad question about what encourages, or allows, individuals actively to participate in aggressive, destructive crowd behaviour when they might not otherwise do so. One factor is the need to belong. For many, if not all, crowd participants, the sense of belonging totally to a higher psychological construct is a transcendental experience: ego boundaries collapse and are invaded by group beliefs, personal responsibility is removed and anxiety is eliminated. A second factor is the way that the human psyche deals with potentially conflicting emotions. Here, an individual disowns the unacceptable side of his or her psyche and projects it out on to others. The result is a toxic combination of infallibility on the one hand and hatred and fear of an ‘enemy’ on the other, and it is all too easy to kill and maim ‘subhuman others’. Unfortunately, the fact that these processes occur in the subconscious mind makes it all too easy to deny that they exist in the first place.

CONCLUSION

The conclusions of this chapter are simple, but profound. Membership of a group in general, or of a crowd in particular, involves the abrogation, to some degree, of personal responsibility – that is, people act differently as crowd participants than they do as independent individuals. A crowd as a whole tends to behave in a non-rational, emotional way in pursuit of its objectives and forces its members to do likewise. The ability of a crowd to organize its members in this way is particularly pronounced under conditions of conflict when the autonomy of the crowd is in some way threatened. These observations go some way towards explaining some of the less attractive features of the human condition. They explain, for example, why armies of otherwise rational and humane men are prepared to go to war; they offer an explanation of why avowedly religious groups have tortured and murdered in pursuit of doctrinal purity; they explain why trade union members have been willing to destroy the companies that they work for rather than surrender any union ‘rights’. The list is endless, and is the more depressing for it.

However, the purpose of this book is other than to bemoan the fate of humanity. Up to now, Part One has presented a body of theory that explains, essentially, why group behaviour is a ubiquitous feature of the human condition. For the vast majority of people, some form of group pressure provides a major motivating force in all their social, economic and political activities. Such pressure exists in such diverse structures as friendly societies, corporations and religions. It is more intense in sports teams and is at its most intense under combat conditions. As we shall demonstrate, the crowd phenomenon also exists in financial markets.

So far we have only explained why crowds exist. We have not yet shown how crowds behave. Let us, therefore, take one further step towards the primary purposes of this book by analyzing the dynamics of a crowd system.

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Forecasting Financial Markets,

Anthony Plummer

Two’s a Crowd

Two’s a Crowd

Two’s a Crowd

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THE INFLUENCE OF GROUPS

It is important to recognize that group behaviour is not, in itself, unusual. In fact, groups emerge as a result of the same basic laws that apply to the rest of nature. As Erich Jantsch2 has shown, building on the implications of quantum physics, all of nature consists of multi-levelled structures. Each level in this hierarchy has the power to organize its lower levels and use them for its own purposes. Consequently, each level is able to perpetuate itself or maintain its identity despite changes in its individual components. This hierarchical structure applies to human society: individuals become members of groups, groups merge to form societies and societies merge to form civilizations.

THE INSIGHTS OF GUSTAVE LE BON

One of the first people to analyze the phenomenon of human groups in any detail was Gustave Le Bon.6 He was fascinated by the influence and role of a very particular type of group – namely, the crowd – in the unfolding of the French Revolution. His seminal book The Psychology of Crowds was written in 1895, but it still stands out as a classic of social psychology. Its analysis has been validated by subsequent analysts such as Sigmund Freud and Carl Jung, as well as by theorists such as Arthur Koestler. Its conclusions have been found to be applicable to such diverse historical phenomena as the Nuremberg Rallies and the Holocaust in Nazi Germany; the attempted destruction of ‘bourgeois’ and reactionary values during the Cultural Revolution in China; and the attempted elimination of individualism by the Khmer Rouge in the Killing Fields of Cambodia. Le Bon saw a crowd as being primarily a psychological phenomenon rather than a physical one (although the two concepts are not necessarily mutually exclusive). He considered that any number of otherwise independent and spatially separate individuals could form a crowd, provided that the members had a common cause. This, of course, confirms the idea that ‘crowd’-type pressures can be found in a large range of groupings. They can, for example, be found in companies, football teams, armies, religious sects and patriotic nation states, as well as riotous mobs. As we shall see, they can also be found in financial markets. Le Bon himself argued that:

The most striking peculiarity presented by a psychological crowd is the following: whoever be the individuals that compose it, however like or unlike their mode of life, their occupations, their character, or their intelligence, the fact that they have been transformed into a crowd puts them in possession of a sort of collective mind that makes them feel, think, and act in a manner quite different from that in which each individual of them would feel, think, and act were he in a state of isolation . . .What really takes place [in the formation of a crowd] is a combination followed by the creation of new characteristics, just as in chemistry certain elements, when brought into contact . . . combine to form a new body possessing properties quite different from those of the bodies that have served to form it.

This profound insight into the nature of crowds used two important concepts: 

a crowd is something other than the sum of its parts – in particular, a crowd has an effective ‘mind’ of its own; 

each individual’s behaviour is altered by their membership of a crowd. 

These two concepts are now central to the general theory of group behaviour. Within this theory, the phenomenon of the crowd presents itself as a special, and extreme, case.

THE GROUP’S ABILITY TO ORGANIZE ITSELF

From the group’s point of view, it is crucial to its own autonomy that it can ‘organize’ its own membership. This is the only way that energy can be directed towards the overall objectives of the group. Such ‘self’-organization operates through the group’s belief system. To be a member of a group, an individual has to accept uncritically the same beliefs as other members of the group. In 1961, the psychoanalyst Wilfred Bion proposed that these beliefs were ‘basic assumptions’ held by group members. In 1976, Richard Dawkins called the beliefs/assumptions ‘memes’. A meme is a simple, self-replicating idea (or habit, or feeling, or sense of things) that spreads from mind to mind. The presence of a particular meme does not necessarily exclude other memes, so a group member can belong to more than one group. However, whatever term might be used for the commonly held beliefs, group members will necessarily suppress behaviour that might cause them to be excluded from the group. In other words, a person’s individuality – or self-assertiveness – will be modified by group membership. This situation obviously means two things:

the more intense is the integrative pull of a group, the less is the degree of individuality that is allowed.

 it is the like-mindedness of group members that gives the group its cohesion.

A group therefore organizes its members via a unifying belief system. In this way, a group becomes something more than just the sum of its parts and group members will reveal a sense of altruism towards one another in the context of group activity. Hence – whether they overtly recognize it or not – group members will act in the interests of the group as a whole.

MIND AS A DYNAMIC PRINCIPLE

This analysis has necessarily been very brief and hardly does justice to the concepts involved. Nevertheless, we now have the tools to enable us to look a little more closely at the idea of a group ‘mind’. This idea is not an easy one either to grasp or to convey. Part of the difficulty lies in our language itself. As commonly used, the word ‘mind’ is taken to refer to that part of the physical structure of the brain that is capable of self-aware, rational thought. According to this view, people have minds, but animals do not. However, this usage not only ignores the role of the so-called ‘subconscious’ mind, but assumes that the physical structure of the brain is identical to, and provides the defining limits for, the inner processes of the mind.

The best way to understand the difference between the concept of ‘brain’ and the concept of ‘mind’ is to recognize that the brain is the structure, while the mind is the processing capabilities that are originated within that structure. Importantly, however, the processes of the mind are not confined to the boundaries established by the physical brain: laterally, the processes extend through the living body, dealing with automatic functions, physical movement and emotions; and, vertically, they extend (layer upon layer) into the depths of the personality. These processes are known generically as ‘mentation’.

The essential point to grasp at this stage is that mentation is primafacie evidence of the phenomenon of life. This was the profound insight of the great philosopher and biologist Gregory Bateson. Bateson found that exactly the same characteristics that define mentation in the human brain can be found both in all the other processes of the human body and in every aspect of nature. Mentation is actually a logical process – a single dynamic blueprint – that is the very hallmark of life on this planet. It does not, therefore, have to be encased in any particular physical structure and, conceptually, can extend beyond all physical structures. The difference between mentation in the human mind and mentation in other aspects of nature is in the quality, or depth, of consciousness. Only human mentation allows for thinking to be aware of itself.

Bateson’s own criteria for the existence of mind (that is, the existence of ‘life’) in any system were essentially four-fold, namely:

the ability to control functions that are internal to the system;

the ability of the system to process information;

the presence of fluctuations in the processing of that information;

the existence of a continuous exchange of energy and information between  the system and its environment.

As we shall see, these criteria produce some very important insights into human behaviour.

THE GROUP MIND

Bateson’s criteria for the existence of mind extended the concept to include all aspects of the living universe and, it may be said, added an important new dimension both to the conclusions of the New Physics and to the framework of the scientific process. Hence, the concept of mind can be used not only to describe the phenomenon of life, but also to describe and explain any particular ‘unit’ of life. It can be found in both the most simple and the most complicated of processes. In terms of human society, it can be found in the dynamics of people’s relationships with one another: it can be found in a small group of people, in a physical crowd, in a nation state or in a whole culture. An individual’s mind may (in a non-self-assertive state) be regarded as a subsystem of a greater whole. Each whole, in turn, has a ‘collective mind’ that organizes its own parts. From this analysis we could say that each and every human grouping may be said to have a collective consciousness.

THE TRIUNE HUMAN BRAIN

As already observed, however, the collective consciousness of a human grouping is qualitatively different from the consciousness of an individual human being. The former is essentially simplistic and is not usually recognized, while the latter is not fully understood, even though it is accepted. The essential difference between the two phenomena is that a group does not have the ability to be aware of its own existence, whereas an individual does have such an ability. And it is this difference that is so important to our study of the influence of a crowd. The fact is that, as described by Le Bon, crowd behaviour involves a dramatic suppression of self-awareness by individuals and an increase in the power of the group entity that is, by definition, not self-aware in the first place. The ‘total’ quality of consciousness therefore deteriorates. As Scott Peck put it, ‘groups are, from a psychological standpoint, less than the sum of the parts’.

We can isolate two aspects to this important phenomenon. First, when an individual adopts a group belief, then, by definition, they also accept a reduction in self-awareness. This is so because the boundaries between the individual and the group become blurred. However, a reduction in self-awareness necessarily happens in all group behaviour. What makes crowd behaviour so distinctive is the degree to which an individual’s self-awareness is suppressed. It seems almost as if there is a switch somewhere in the brain that flicks self-awareness to ‘off’ whenever a crisis arises.

This brings us to the second aspect of the deterioration in the quality of consciousness that accompanies the crowd phenomenon. There does seem to be something of a fault-line within the structure of the human brain. The problem stems from the fact that the brain consists of three main processing areas that can, to some extent, operate independently of one another. Each part is structurally and chemically different from the other parts, and appears to have its own intelligence, its own memory and its own separate functions. The brain stem (the innermost part of the brain) is concerned primarily with instinctive behaviour patterns, biological drives and compulsive behaviour. Surrounding this part is the limbic system, which is mainly involved with the recreation of external experiences in the ‘inner’ world, and with emotional activity. Importantly, it is also the area of the brain that is most concerned with group activities. Finally, the neocortex (the outermost part of the brain) deals with the ability both to be aware of the thought process itself, and to anticipate the future and recreate the past. It also contains the areas of the brain (the so-called ‘frontal lobes’) that are most involved with concern for humanity. Because of its three-fold nature, the American neurophysiologist Paul D Maclean has called the human brain the ‘triune’ brain.

THE NEOCORTEX

Of the three areas, it is undoubtedly the neocortex that (among other things) separates humankind from other mammals. The evolutionary history of the neocortex is, however, uncertain. No one really knows when (or how, or why) it first appeared. Current guesswork suggests it developed only during the last 50 million years or so. This compares with more than 150 million years for the limbic system, and more than 250 million years for the brain stem. Importantly, evidence from the evolution of civilization18 suggests that the specific abilities associated with the neocortex have only developed within a very recent period. The modern ego – that is, the tendency of mental processes to organize themselves in such a way as to assert themselves as an independent entity – seems only to have arisen some four thousand (or so) years ago. The ego, therefore, is very young in terms of evolution. We can therefore hypothesize that the operation of the neocortex can easily be overwhelmed for two related reasons:

the neocortex has still not yet been properly integrated with theother two parts of the brain;

the capability of ‘self’-awareness is still likely to give way to morearchaic states of consciousness when an ‘external’ authority is favoured.

THE AMYGDALA

In fact, research by Joseph LeDoux at New York University has found that the main problem almost certainly rests with a tiny part of the human brain known as the ‘amygdala’. The amygdala is a small neural cluster that lies between the brain stem and the limbic system. It is responsible both for storing information about emotional events and for scanning the environment for patterns that match those events. Despite the fact that it is very small (about an inch long), it receives a vast range of inputs from the visual, auditory and olfactory systems, and it connects to innate behaviours and physiological responses via the brain stem. Once aroused, the amygdala immediately triggers an emotional and physiological reaction. The critical point is that the arousal starts before the neocortex has even had a chance to register an incoming signal. If the arousal relates to a threat, and if the threat is significant, then the neocortex has very little chance to intervene. Consequently, we might jump out of the way of an oncoming bus or remove our hand from something hot, and only recognize what has happened after the event.

More generally, once a threat has been perceived and the amygdala has activated an emotional and physiological reaction, the range of potential behaviours tends to narrow down to the fight–flight–freeze complex. Since we all have limited experience, and none of us has access to all the available information, we become acutely aware of what others are doing. This is the trigger for the ‘herd’ instinct in human beings.

The amygdala has been implicated in emotions that generate feelings of well-being, as well as those that are fear-based. The fact remains, however, that its evolutionary function is to enhance survival prospects, and it can be aroused before we even realize it. Perhaps, for many of us, it is too sensitive and needs positive intervention to be ‘retrained’. In the meantime, it is quite obvious that the amygdala is influential in the formation of crowds.

THE RESPONSE TO A THREAT

Significantly, a crowd is most likely to emerge in the presence of a threat of some kind. A group of people can have a common cause, but will not be regarded as a crowd, as such, until a threat appears. A crowd has a certain urgency and immediacy to it, which is not necessarily present in a group. Hence, there are two possibilities:

a number of individuals will feel threatened in some way and then form a crowd;

a group already exists that is then sufficiently threatened to transmute into a crowd.

In either case, it is not fanciful to suggest that crowd members’ emergency amygdala circuits will be triggered. As a result:

group survival needs overwhelm individual self-assertiveness needs;

group beliefs replace personal beliefs;

the influence of the neocortex is overwhelmed by the influence of the brain stem and the limbic system.

Crowds are, accordingly, involved primarily with instincts, biological drives, compulsive behaviour and emotions. Hence, their behaviour is essentially non-rational (and is, in fact, often irrational). To paraphrase Arthur Koestler:

emotion and intellect, faith and reason, [are] at loggerheads. On the one side, [is] the pale cast of rational thought, of logic suspended on a thin thread all too easily broken; on the other, [is] the raging fury of passionately held irrational beliefs, reflected in the holocausts of past and present history.

THE ‘INTELLIGENCE’ OF CROWDS

This certainly helps to explain the popularly held delusion that all members of a crowd are unintelligent: it is not that they are unintelligent as such – it is that their ability to remain self-aware and think logically becomes suppressed in the face of a threat. This is as true of pairs of individuals confronted with a challenge (such as a couple whose child-rearing abilities are criticized) as it is of a large group of people facing a physical threat (such as a military unit under fire).

Whether or not the challenge to a crowd is physical, it almost certainly involves a threat to its underlying belief system. As a result, the strength of this belief system becomes intensified and severe limitations are accordingly imposed on the quality of data that the crowd will recognize as genuine information. Gregory Bateson defined information as ‘differences which make a difference’. A crowd mind can usually only perceive differences that are relatively large and that occur over very short periods of time. In other words, a crowd will only recognize obvious changes. Slow changes can be observed only by the lengthy process of continually, and rationally, scanning all the potentially relevant data. Crowds are incapable of such analysis: they think in terms of simple images and communicate with slogans. As they emerge in times of crisis, they are all too often the main vehicle for historical ‘progress’.

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Forecast Financial Markets,

Anthony Plummer

Buying the Apocalypse

Buying the Apocalypse

 Buying the Apocalypse

Remember the Speculator’s Edge…to demand supply and supply demand. Doing your job as a speculator sometimes requires buying when there’s blood in the streets or under other circumstances when all but the bravest are selling. Indeed, the best trade (investment) imaginable would be buying stocks at the Apocalypse. You’d get them while their worth less than their intrinsic value (value of future cash flows discounted back to the present). The discount rate is the yield on the ten year bill (the risk-free rate) which is now under one percent…Therefore those future cash flows will be discounted by very little...In other words think long term where there is less competition for the information that really matters. And remember at times of emotional extremes, be contrary. Don't be part of the herd...stand apart!

A few reassuring words from Bruce Flatt from his latest letter to the shareholders…

While we manage our underlying business for the long term, we realize that you are also interested in our stock performance. Its 50% increase in 2019 was an anomaly; at the same time, the previous year the share price was down, which we also viewed as an anomaly. We estimate that we earned approximately 20% annual returns on our intrinsic value over the two years. As a result, over the two years combined, our stock had a return that was about the same as what we generated in the business.

In short what is now happening in the stock market is an anomaly. The run-up up to the current sell-off was an anomaly…Focus on long term values…hold your nose and buy or just hold on to what what you have. 

Remember, at times of extreme emotion...BE CONTRARY!

How to Calculate and Analyze Warren Buffett's Owners Earnings

How to Calculate and Analyze Warren Buffett's Owners Earnings

In this article, I will show you how to calculate and analyze Warren Buffett's owners earnings figure. Owners earnings, or cash flow for owners, is a figure that is commonly used for intrinsic value calculations, and is one of the best figures to depict how much cash one can get out of an investment. It was popularized by Warren Buffett in his 1986 Berkshire Hathaway shareholder letters.

Many investors use earnings per share (EPS), net income, or some other figure to assess the cash generated for investors. However, the number that Warren Buffett uses is called "owners earnings," which is a term that many investors are unfamiliar with.

Investors make money in the stock market in two ways:

1. Capital appreciation: When the stocks an investor owns appreciates in value over time, and the investor sells the stocks to profit the difference.
2. Dividend payments: Payments that dividend-paying companies give out to investors for holding their stock.

As an investor, you can analyze the cash flows a business generates to see how these internal cash flows convert into capital gains and dividends. In the process, you'll be able to better assess the value of a company and determine its earnings, which can lead to more confident investment decisions.

Owners earnings is therefore one of the best figures you can use to determine how much cash goes back to the company's owners, and the real dollar amount owners can withdraw without harming operations.

So, in this article, I will show you how to calculate and analyze owners earnings, and make sense of all of its components. I will also provide you with several examples along the way.

Warren Buffett's Owners Earnings

Finding owners earnings will provide you with a more accurate depiction on how much cash is left over after the normal operations of the business.

Warren Buffett's first mention of the phrase "owners earnings" was in his 1986 Berkshire letter, as quoted below:

"If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N's items (1) and (4) 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. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)"

— Warren Buffett | 1986 Letter to the Shareholders

The formula below captures what Buffett is saying here about calculating owners earnings:

Owners earnings = Net income + Non-cash charges - Maintenance capital expenditures (CapEx)

where:

• Non-cash charges: Includes depreciation, depletion, amortization, impairment charges, and any other non-cash charges.
• Maintenance CapEx: Money a company spends to maintain the normal operations of the business.

Buffett's formula for owners earnings can also be simplified into the formula below:

Owners Earnings = Operating cash flow - Maintenance capital expenditures (CapEx)

where:

• Operating cash flow: Cash generated from the normal operations of a company.

The difference here is that "net income + non-cash charges" in the formula above is replaced with "cash flow from operations," from the cash flow statement. This alternative owners earnings formula is typically more accurate as net income can be manipulated and non-cash charges often differ between companies. This formula also happens to be easier to calculate, which is ideal. Now, let's go through each of these two components and understand what they are in more detail and how you can go about finding them.

Operating Cash Flow

Operating cash flow is otherwise known as "net cash provided by operating activities," "net cash generated by operating activities," or something similar along those lines.

This is the easier component of the formula, as this figure is already calculated and provided to us by companies in their annual reports. Simply go to your chosen company's investor relations page, click on any 10-K annual report, and navigate to the cash flow statement.

If you're having trouble finding your company's annual report or want to become more familiar with 10-K annual reports before proceeding, I would recommend reading this article on How to Read and Analyze Any 10-K Annual Report.

The statement of cash flows has three sections:

• Operating Activities: Includes the real cash inflows and outflows that are related to the normal operations of the business. This includes the costs of running the business on a day-to-day basis, and includes the costs associated with sustaining the company's core business model.
• Investing Activities: Includes cash flows that are used to purchase assets that the company expects to produce value for many years to come. This is where companies spend their money and invest it on purchasing buildings, machinery, and even making acquisitions.
• Financing Activities: Includes all the cash flows related to financing. This includes raising debt, paying down debt, delivering capital to shareholders, paying dividends, raising shares, and buying back shares.

The number we're looking for is the "cash from operating activities" (or something very similar). This is shown on the last line under operating activities, or the first section of the statement of cash flows.

This is also outlined below, with Microsoft's (MSFT) most recent cash flow statement as an example:

MSFT: Cash Flow Statement

For the first component of the owners earnings formula, you should look at the net cash generated from your company's normal operations. In our case, I will use the most recent figure ($52.185 Bil.) for this example.

Capital Expenditure Overview

After locating the operating cash flow from the operating activities section of the cash flow statement, the next step is to find and subtract the maintenance CapEx. Again, this is needed to compute owners earnings.

Unfortunately, companies typically do not outright provide maintenance CapEx in their 10-K annual reports. Therefore, this number is a little bit trickier to solve, unlike the operating cash flow number which is always provided.

But first, before learning how to compute maintenance CapEx itself, it's important to begin with just total CapEx.

Capital Expenditure

Capital expenditure (total CapEx) is considered an investing cash flow on the cash flow statement.

As mentioned before, this is where companies are spending their money and purchasing long-term assets which they hope to provide value for the business over the long-term. Total CapEx is therefore considered as an investing activity and relates to buildings, property, plant, and equipment. This is commonly referred to on the cash flow statement as property, plant and equipment (PP&E).

Therefore, if you see a line on the cash flow statement called "cash spent on property, plant and equipment," or something similar, this is essentially what capital expenditure is.

For Microsoft, this is shown as "Additions to property and equipment" as outlined below:

MSFT: PP&E on Cash From Investing Section

As you can see, Microsoft had $13.925 billion of total CapEx in 2019.

Sometimes, the number shown here is not the actual total CapEx amount. For example, for Apple (AAPL), a massive multinational technology company (which I'm sure you've heard of), the number for capital expenditure (PP&E) that is shown on the cash flow statement is not accurate. Instead, you have to do a search for "capital expenditure" in their 10-K annual report to find the actual number.

Therefore, I would recommend searching the term "capital expenditure" or "capital assets" when you are seeking this information for any company, just to ensure that you're looking at the right number.

Components of Total Capital Expenditure

Now that we have the total CapEx number, the next step is to figure out maintenance CapEx. What this really means, is that we need a component of this total CapEx number.

In reality, total CapEx falls into two categories:

1. Growth CapEx: When companies spend money to grow and improve their business, in an attempt to produce more cash in the future, this is considered as growth CapEx. This includes any investments made for building purchases or upgrading company equipment.
2. Maintenance CapEx: This is the figure that we're trying to find, and it's how much money the company is spending just to maintain the business and its operations. For example, if a piece of machinery were to break down, the company would spend money to restore it. Because restoring this piece of machinery doesn't improve the cash flows of the business, and is not seen as an investment that grows the business, it's considered a maintenance CapEx.

Although rare, some companies actually make a distinction in their annual reports as to how much was spent on maintenance and how much was spent on growth.

For example, management in the annual reports may say:

"Total capital expenditure was $100 million for 2019. We spent about $60 million maintaining the business and $40 million on growth potential."

Below is an example of Phillips 66 (PSX), a large energy manufacturing and logistics company, where growth and maintenance CapEx are described and separated:

Phillips 66: Executive Overview

Outlined above are the total cash from operating activities number, which can also be seen on the cash flow statement, and the total $5.3 billion Phillips 66 expects to budget for its growth CapEx category.

The "Operating Excellence," or maintenance CapEx, is what we have to solve for. We can do this with the provided total CapEx ($5.764 Bil.) found in the cash flow statement:

Phillips 66: CapEx

Therefore, Phillips 66's maintenance CapEx for 2016 would be $464 million ($5.764 Bil. - $5.3 Bil). Then, using the $5.713 billion in cash from operating activities, we can subtract the $464 million to solve for owners earnings. This would result in $5.249 billion in owners earnings.

Unfortunately, most companies, including Microsoft, do not provide this much information in their annual report. Therefore, as investors, we have to make an educated estimate on what is maintenance and what is growth from the total CapEx number. This will provide us with a more accurate owners earnings calculation.

Shortcut to Maintenance Capital Expenditure

If you do not want to go through the trouble of estimating the portion of maintenance and growth from the total CapEx number, the most conservative method you can use is to simply assume that all of the total CapEx (aka PP&E) amount is maintenance.

If you solve for owners earnings in this manner, what results is a number called free cash flow (FCF):

Free cash flow (FCF) = Cash from operations - Total capital expenditures (CapEx)

FCF is the cash available to repay debt and make dividend payments after operating expenses and capital expenditure requirements are paid off. You can just use the FCF number if you don't want to spend your time figuring out the specifics of the growth and maintenance CapEx numbers.

However, I would highly suggest that if you want to more accurately value a business, then you should try your best to distinguish between growth and maintenance CapEx.

How to Find Maintenance Capital Expenditure

For companies where growth and maintenance CapEx are not distinguished, you'll have to estimate this maintenance CapEx figure to solve for the owners earnings figure.

If you have not already done so, the first step is to locate the total CapEx number, as previously covered. The next step is to figure out what proportion of this total CapEx number is maintenance, and what proportion is growth.

Besides management outright telling us the proportions of maintenance and growth CapEx (as shown in the Phillips 66 example), there are two ways management will talk about maintenance CapEx in the 10-K annual reports:

Maintenance CapEx is Implied

Management commonly implies the growth and maintenance CapEx figures. This is when maintenance CapEx is stated, in some way or another, but not in a clear fashion. In other words, maintenance CapEx is merely implied or suggested through the way management has written it, and not clearly given. Therefore, it's not clear on how much exactly goes towards growth or maintenance CapEx.

An example of this is Jack In The Box (JACK), a large fast food restaurant chain. As you can see in the image below, CapEx is broken down into multiple categories and a description. For this particular example, you can focus your attention on the outlined area:

JACK: CapEx

For Jack In the Box, you could therefore assume that the following items are growth CapEx numbers, as money is being spent to grow the business:

• New restaurants
• Purchases of assets intended for sale or sale and leaseback
• Other, including facility improvements
• Information Technology (for both restaurants and corporate services)

On the other hand, you can likely infer that only "restaurant facility expenditures" is maintenance Capex, as it relates to the operational expenses required to sustain the business. Although this estimation may not be the most accurate, I used the description below the total CapEx number and my knowledge on growth and maintenance CapEx to make the best judgement I could.

Clearly, this differentiation is not always super clear or explicit, and those who are more knowledgeable about a particular business and the industry it's in can likely provide a more accurate estimate on this maintenance CapEx number.

Maintenance CapEx is Not Provided

Often times, management will not say anything about maintenance CapEx in their 10-K annual reports. Instead, they would only list their total CapEx number and would provide generic information on what they spent their money on.

This is when we are forced to make more vague maintenance CapEx estimations, or take the longer approach and attempt to calculate it as discussed in next section.

There are two general things you can do when maintenance CapEx is not given or implied:

1. Estimate a percentage: You would estimate the percentage of maintenance and growth CapEx based on the business and industry knowledge you have. If you read through the most recent 10-K annual report, management will likely make a few comments on CapEx spending, which can help you make a more accurate estimation.
2. Assume all of CapEx is maintenance: You can be extremely conservative and approach the problem in this manner, and calculate free cash flow (FCF) as mentioned before. However, if you were to do this, you would assume nothing is being spent on growth, even though this does not necessarily hold true. Regardless, this is what I would recommend doing if you are in doubt and cannot make an accurate percentage estimate.

If you want to avoid vague maintenance CapEx estimates, or if you want to double-check any assumptions you may have made, then it's never a bad idea to read the next section where a more involved process will be used to calculate maintenance CapEx. However, if you feel confident in the maintenance CapEx you have estimated, there is nothing wrong with computing owners earnings from here on.

How to Calculate Maintenance Capital Expenditure

The simplest way to calculate maintenance CapEx is to just use a figure called "depreciation and amortization," found on the financial statements, as this accounts for the diminishing value of an asset over time:

Maintenance CapEx = Depreciation and amortization

Although you can use this as a solution, there is one major flaw (if not more).

The problem, is that depreciation can be misleading at times, which can lead to an unrealistically high number for maintenance CapEx calculations. Accounting-related depreciation is misleading, as it can be higher due to price reductions from technological advancements. Depreciation can also be lower in an inflationary environment, where reproduction costs are higher.

Therefore, although it's a more involved process, using Bruce Greenwald's method of calculating CapEx is the next step you should take, as it works towards finding true depreciation.

Bruce Greenwald's Maintenance CapEx Calculation

Bruce Greenwald is widely recognized for his authority on value investing, and his method for calculating maintenance CapEx is ideal when it's not provided in the 10-K annual reports, or if you cannot make an accurate estimation.

In Bruce Greenwald's book: Value Investing: From Graham to Buffett and Beyond, he describes how you can go about calculating maintenance CapEx. This is summarized in the bullet points below: (Source)

• Calculate the average gross property, plant and equipment (PP&E)/Sales ratio over 7 years.
• Calculate current year's increase in sales.
• Multiply the PP&E/Sales ratio by the increase in sales to get growth CapEx
• Subtract the computed growth CapEx from the CapEx figure (in the cash flow statement) to get maintenance CapEx, which is the true depreciation for the company.

Now, I will use Microsoft's actual Sales and PP&E (total CapEx) numbers from their past seven financial statements, so that I can calculate their maintenance CapEx (which is not given on their annual reports).

The two table shown below show how you can go about setting up Greenwald's method for calculating maintenance CapEx, in this case for Microsoft. I've broken this down into steps and two different methods as well. Whichever method you use doesn't matter, although method #2 is a lot more simpler.

Method #1

See the table and steps 1-5 below:

$MSFT	2014	2015	2016	2017	2018	2019	2020
Sales	$86,833	$93,580	$91,154	$96,571	$110,360	$125,843	$143,015
Change in Sales ($)	$6,747	$(2,426)	$5,417	$13,789	$15,483	$17,172
PP&E (CapEx)	$5,485	$5,944	$8,343	$8,129	$11,632	$13,925	$15,441
Change in PP&E (CapEx) ($)	$459	$2,399	$(214)	$3,503	$2,293	$1,516
PP&E/Sales Ratio	6.32%	6.35%	9.15%	8.42%	10.54%	11.07%	10.80%
Growth CapEx	$604	($217)	$485	$1,234	$1,386	$1,537
Maintenance CapEx	$5,340	$8,560	$7,644	$10,398	$12,539	$13,904

Values are in millions of U.S. $

• Step 1: The first step is to find revenue (sales) and the plant, property and equipment (PP&E), which we also know as total CapEx, for the last seven years. This information can be found on the income statement and cash flow statement.
• Step 2: The next step is to take PP&E (CapEx) and divide over sales. This will provide you with the PP&E/Sales ratio, which shows how much the company needs to invest in PP&E to generate $1 of sales. For example, in 2020 Microsoft needed about $0.108 in PP&E to generate $1 in sales ($15,441 / $143,015).
• Step 3: Average the PP&E/Sales ratio from 2013 to 2020, to normalize company movement and distortions caused by business cycles. For Microsoft, this comes to 8.95%, which we will then use to compute growth CapEx.
• Step 4: Compute growth CapEx using the 8.95% figure. You can do this for every year. For example, in 2020, this would be $1,537 in growth CapEx ($15,441 x 0.0895). Note that although we have 7 years worth of sales and PP&E (total CapEx), 2014 data is only used to calculate the average PP&E/Sales ratio and the annual changes for Sales and PP&E.
• Step 5: Finally, solve for maintenance CapEx by taking the PP&E (CapEx) figure and subtracting the computed growth CapEx figure for the year. For example, in 2020, this would be $13,904 ($15,441 - $1,537). The latest CapEx figure is also the most relevant for computing owners earnings.

Method #2

Alternatively, you can follow step 1 and step 2 above (skip steps 3-5), and then just apply the formula shown below to estimate maintenance CapEx:

Maintenance CapEx = CapEx - (PP&E % of sales * Sales growth (decrease))

In this case, you do not have to average out PP&E/Sales Ratio and apply it to growth CapEx. Instead, you're directly solving for maintenance CapEx. This is shown below:

$MSFT	2014	2015	2016	2017	2018	2019	2020
Sales	$86,833	$93,580	$91,154	$96,571	$110,360	$125,843	$143,015
Change in Sales ($)	$6,747	$(2,426)	$5,417	$13,789	$15,483	$17,172
PP&E (CapEx)	$5,485	$5,944	$8,343	$8,129	$11,632	$13,925	$15,441
Change in PP&E (CapEx) ($)	$459	$2,399	$(214)	$3,503	$2,293	$1,516
PP&E/Sales Ratio	6.32%	6.35%	9.15%	8.42%	10.54%	11.07%	10.80%
Growth CapEx	$429	$(222)	$456	$1,453	$1,713	$1,854
Maintenance CapEx	$5,515	$8,565	$7,673	$10,179	$12,212	$13,587

Values are in millions of U.S. $

As you can see, the end result does not differ too much between the two methods (Method #1: $13,907 vs. Method #2: $13,587). This is because you're essentially applying the same concept, just in a different manner.

Conclusion

This method works best for companies that are relatively consistent, but not for companies who experience a sales growth number greater than the PP&E (total CapEx) figure. It also doesn't work well for commodity-based businesses.

This method is not a perfect solution to finding the maintenance CapEx number. Regardless, it's the best calculation-based method out there, and can be utilized when all else fails. However, if you're not confident in the solution you arrive at using Greenwald's method, then just stick with using the total CapEx figure and calculate free cash flow (FCF) instead.

The Bottom Line

In summary, owners earnings, popularized by Warren Buffett, is one of the best figures you can use to estimate how much cash is left over after the normal operations of the business for its shareholders.

Owners earnings can be calculated by subtracting maintenance capital expenditures (CapEx) from the operating cash flows of a business. This is a rather simple calculation, but maintenance CapEx is a number that is not always explicitly provided, and often times needs to be estimated through various means in order to solve for owners earnings.

However, once accomplished, this owners earnings number can be applied to your intrinsic company valuations (in replace of free cash flow (FCF)), to more accurately determine whether a stock is overvalued or undervalued at its current stock price. Therefore, it's in your best interest to become comfortable with finding the components of owners earnings, so that you can make more informed and accurate investment decisions in the future.

Source

https://stablebread.com/how-to-calculate-and-analyze-warren-buffetts-owners-earnings/#:~:text=Owners%20earnings%2C%20or%20cash%20flow,1986%20Berkshire%20Hathaway%20shareholder%20letters.