Warren Buffett, the mastermind of the investment world, believes that “Owners’ 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. Owner’s earnings can be calculated from the following formula:
Owners earnings = Net income + Depreciation and amortization – Capital investment – Additional working capital needs.
Investors 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 non-cash items, must be added back to income to arrive at income that reflects the net cash flow from the organization’s operating activities. Buffett views depreciation as a historical cost that should not be incorporated into the calculation of net income. Furthermore, he argues that amortization of items such as goodwill is unrealistic. This is because the firm’s goodwill 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 spending is deducted from gross profit known as depreciation to arrive at net income. Warren Buffett states that the actual capital spending that has taken place in the year must be subtracted from net income so that an investor can calculate the actual value of the free cash flows that have been generated after deducting all expenses along with capital spending. . This is because the capital expenditure has resulted in sales generation for the given year and must be deducted to reflect 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 should be reflected in owner’s income. If working capital requirements have increased, the net effect must be deducted, while if they have decreased, the net effect must 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 and 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.
