Warren Buffett, the brains of the investment world, believes that “Owner Earnings” is a true measure of a company’s valuation. He believes that the company’s free cash flows determine the wealth attributable to the organization’s shareholders who are actually the owners of the company. The owner’s earnings can be calculated from the following formula:
Owners’ profit = Net income + Depreciation and amortization – Capital investment – Additional working capital needs.
Investors who are familiar with the concept of economic value added will find that Warren Buffet’s formula is based on the calculation of free cash flow arising from the investment. But what exactly is the reasoning behind the equation? Well, for starters, net income is an accrual-based calculation that considers cash and non-cash items; Therefore, depreciation and amortization, which are noncash items, must be added back to revenue to arrive at revenue that reflects the net cash flow from the organization’s operating activities. Buffett views depreciation as a historical cost that should not be factored into the calculation of net income. Furthermore, he argues that the amortization of items such as goodwill is not realistic. This is because the company’s equity is likely to increase over time rather than decrease.
The next item in the equation is capital spending that is not part of net income on the income statement. Rather, a fixed percentage of capital expenditure is deducted from gross profit known as depreciation to arrive at net income. Warren Buffett states that the actual capital expenditure that has taken place in the year must be subtracted from the net income so that an investor can calculate the real value of the free cash flows that have been generated after the deduction of all expenses along with capital spending. . This is because the capital expense has resulted in the generation of sales for the given year and must be deducted to reflect the true net income in a given year.
Similarly, the organization’s working capital needs should be calculated by determining the net changes in each of the components of the working capital cycle, namely creditors, debtors, and inventories. Net changes in working capital must be reflected in the owner’s income. If working capital requirements have increased, the net effect should be deducted, while if they have decreased, the net effect should be added back to net income.
The end result of the calculation is the generation of free cash flows that are attributable to the owners of the organization that can be reinvested or used to pay dividends to shareholders. Owner’s earnings, in essence, are net income that takes into account all investing activities and adds all non-cash items back to net income. The final answer indicates the company’s ability to generate cash from the investment made by shareholders in terms of capital.
