Warren Buffet’s formula on Value Investing – Owner’s Earnings
What is Owner’s Earnings?
Most of us as investors use various metrics and formulas to assess the value of a company.
We have heard and used various metrics like EPS, Earnings Yield, Free Cash Flow etc., to determine the operating success of a business.
Berkshire Hathaway among various other measures uses a different and even to mention a little known metric to value a business called “Owner’s Earnings”.
Warren Buffett announced about this in his 1986 Berkshire Shareholder letter.
In his own words from the letter,
“[Owner earnings] 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.”
This metric tells us whether the business could continue to be successful on its operating strength alone or will it regularly need alternative sources of funding like – Debt, Dilution of Equity etc.,
Net Income, EPS, etc., are good metrics, but the net cash that gets to owner’s pocket is very different usually. That is why Warren Buffett called this as “Owner’s Earnings”.
Essentially, Owner’s earnings are the cash that goes directly to shareholder’s pockets after every income and expense accounted for.
It is the cash which could be taken out of a business every year after deducting capital expenditures and working capital required the maintain the business.
Is Free Cash flow and Owner’s Earnings the same or different?
Though few times both Free cash flow and Owner’s Earnings might look like the same and even may provide you same or very close results out of calculations, there are times it will be greatly different which can have a great impact on the net intrinsic value arrived at.
Firstly, Free Cash flow – taken usually from the Cash flow statement includes all types of Capital Expenditures incurred – for both maintenance and growth.
But, Owner’s earnings considers only the ‘maintenance capex’ – capital expenditure done in plant, machinery and even in research and development etc., that are required only to maintain or run the business.
Secondly, Free Cash flow – taken usually from the Cash flow statement includes ‘changes to working capital’, which may fluctuate widely year on year.
But Owner’s earnings considers only the necessary changes in working capital that are required to maintain or run the business.
Formula for calculating Owner’s Earnings
Owner’s Earnings = (Net Income + Depreciation + Amortization + Other Non-Cash charges) –
(Average Maintenance Capex and Necessary changes in Working Capital that are required to maintain the business)
Here, Net Income, Depreciation, Amortization etc., can be taken directly from the Cash Flow statement.
Non-Cash charges are usually one or more or similar to the following – Changes in Receivables, Changes in Payables, Changes in Inventory, Gain/Loss on Sale of Assets, Investments, Stock options given to employees etc.,
However, ‘maintenance capex’ is not a readily available number and hence often difficult to determine, but, if can be arrived at by analysing the pattern of capex of the company for past several years.
If the Owner’s Earnings is consistently growing for the past decade, then it is a good sign of a business that will be capable of surviving entirely on its operational excellence in the future also.
In my opinion calculating owner’s earnings is a very useful and could also be fool-proof but, more of an art than science.