Owner earnings is a
valuation method detailed by
Warren Buffett
Warren Edward Buffett ( ; born August 30, 1930) is an American business magnate, investor, and philanthropist. He is currently the chairman and CEO of Berkshire Hathaway. He is one of the most successful investors in the world and has a net w ...
in
Berkshire Hathaway
Berkshire Hathaway Inc. () is an American Multinational corporation, multinational conglomerate (company), conglomerate holding company headquartered in Omaha, Nebraska, United States. Its main business and source of capital is insurance, from ...
's annual report in 1986.
He stated that the
value of a company is simply the total of the net
cash flow
A cash flow is a real or virtual movement of money:
*a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are expected ...
s (owner earnings) expected to occur over the life of the business, minus any reinvestment of earnings.
Buffett defined owner earnings as follows:
:"These represent (a) reported
earnings Earnings are the net benefits of a corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are used as EBIT (earnings before intere ...
plus (b)
depreciation
In accountancy, depreciation is a term that refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the a ...
,
depletion,
amortization
Amortization or amortisation may refer to:
* The process by which loan principal decreases over the life of an amortizing loan
* Amortization (accounting), the expensing of acquisition cost minus the residual value of intangible assets in a system ...
, 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... Our owner-earnings equation does not yield the deceptively precise figures provided by
GAAP
Gaap (also ''Tap'', ''Coap'', ''Taob'', ''Goap'') is a demon that is described in demonological grimoires such as ''the Lesser Key of Solomon'', Johann Weyer's ''Pseudomonarchia Daemonum'', and the Munich Manual of Demonic Magic, as well as Jac ...
, since (c) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes... All of this points up the absurdity of the '
cash flow
A cash flow is a real or virtual movement of money:
*a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are expected ...
' numbers that are often set forth in
Wall Street
Wall Street is an eight-block-long street in the Financial District of Lower Manhattan in New York City. It runs between Broadway in the west to South Street and the East River in the east. The term "Wall Street" has become a metonym for t ...
reports. These numbers routinely include (a) plus (b) - but do not subtract (c)."
Estimating Average Capital Expenditures
Average annual capital expenditures is, as Buffett mentions, an estimate. This number may be separated into maintenance capital expenditure (what's required to keep the business operating at current levels) and growth capital expenditure (what's required to grow the business). The most straightforward way to calculate maintenance capital expenditure is to simply use depreciation, amortization, and depletion. But those numbers don't necessarily reflect reality since depreciation schedules and the like don't necessarily line up with their actual useful lives. Similarly, simply using the most recent period's capital expenditure may not be representative of the annual capital expenditure required to run the business and it may also include a portion of "growth" capital expense.
One way, as proposed by
Bruce Greenwald
Bruce Corman Norbert Greenwald (born August 15, 1946), is a professor at Columbia University's Graduate School of Business and an advisor at First Eagle Investment Management. He is, among others, the author of the books ''Value Investing: fr ...
, to approximate maintenance capital expenditure, for use in an owner earnings calculation is to use a ratio of capital expenditure to sales over multiple past years. As formulated by Greenwald, this approximation works by:
# Sum of property, plant, and equipment (PPE) from the balance sheet for the past 5 years
# Sum sales from the income statement for the past 5 years
# Dividing the sum of PPE by the sum of sales to find the average ratio of PPE-to-sales
# Multiply the PPE-to-sales ratio by the nominal increase or decrease in sales from the prior year to the current year to find growth capital expenditure
# Subtract calculated growth capital expenditure from the current year's capital expense on the balance sheet to find maintenance capital expenditure.
See also
*
Berkshire Hathaway
Berkshire Hathaway Inc. () is an American Multinational corporation, multinational conglomerate (company), conglomerate holding company headquartered in Omaha, Nebraska, United States. Its main business and source of capital is insurance, from ...
*
Business valuation Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Here various valuation techniques are used by financial market participants to determine the price they are willing t ...
*
Cash flow forecasting
Cash flow forecasting is the process of obtaining an estimate or forecast of a company's future financial position; the cash flow forecast is typically based on anticipated payments and receivables.
See Financial forecast for general discussion ...
*
Valuation (finance)
In finance, valuation is the process of determining the present value (PV) of an asset. In a business context, it is often the hypothetical price that a third party would pay for a given asset. Valuations can be done on assets (for example, inve ...
*
Value investing
Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham ...
References
External links
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{{DEFAULTSORT:Owner Earnings
Berkshire Hathaway
Management accounting
Business terms
Valuation (finance)