Warren Buffett, the mastermind of the world of investments, believes that the “Owners Earnings” is a true measure of valuation of a company. He believes that free cash flows of the company determine the wealth that is attributable to the shareholders of the organization who are in reality the owners of the company. The owner’s earnings can be calculated from the following formula:
Owners Earnings = Net Income + Depreciation and Amortization – Capital Investment – additional Working Capital needs.
Investors that are familiar with the concept of economic value added would find that the Warren Buffets formula is based upon calculating the free cash flow that comes about from the investment. But what exactly is the reasoning behind the equation? Well to start with, the net income is an accrual based calculation that considers cash and non cash items; therefore, depreciation and amortization, that are both noncash items, must be added back to the income to arrive at the income that reflects the net cash flow from operating activities of the organization. Buffett regards depreciation as a historical cost that should not be incorporated in the calculation of net income. Moreover, he argues that amortization of items such as goodwill is unrealistic. This is because the goodwill of the company is likely to increase with the passage of time rather than decrease.
The next item within the equation is the capital expenditure that does not form a part of the net income within the income statement. Rather a fixed percentage of the capital expenditure is deducted from the gross profit known as the depreciation to arrive at the 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 true value of free cash flows that have been generated after the deduction of all expenditures along with the capital expenditure. This is because the capital expenditure has resulted in the generation of sales for the given year and must be deducted in order to reflect the true net income in a given year.
Similarly, the working capital needs of the organization must be calculated by determining the net changes in each of the components of the working capital cycle namely the creditors, debtors, and stock. The net changes in the working capital must be reflected in the owner’s income. If the working capital requirements have increased, the net effect must be deducted while if they have decreased, the net effect must be added back to the net income.
The ultimate result of the calculation is the generation of free cash flows that are attributable to the owners of the organization which might either be reinvested or used to pay out dividends to the shareholders. The owner’s earnings, in essence, are the net income that takes into account all the investing activities and adds back all the non-cash items to the net income. The final answer indicates the ability of the firm to generate cash from the investment made by the shareholders in terms of equity.