Owner earnings is a
valuation method detailed by
Warren Buffett in
Berkshire Hathaway
Berkshire Hathaway Inc. () is an American multinational conglomerate holding company headquartered in Omaha, Nebraska. Originally a textile manufacturer, the company transitioned into a conglomerate starting in 1965 under the management of c ...
's annual report in 1986.
He stated that the
value of a company is simply the total of the net
cash flow
Cash flow, in general, refers to payments made into or out of a business, project, or financial product. It can also refer more specifically to a real or virtual movement of money.
*Cash flow, in its narrow sense, is a payment (in a currency), es ...
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 {{Short description, Financial term
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 u ...
plus (b)
depreciation
In accountancy, depreciation refers to two aspects of the same concept: first, an actual reduction in the fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wears, and second, the allocation i ...
,
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... Our owner-earnings equation does not yield the deceptively precise figures provided by
GAAP, 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
Cash flow, in general, refers to payments made into or out of a business, project, or financial product. It can also refer more specifically to a real or virtual movement of money.
*Cash flow, in its narrow sense, is a payment (in a currency), es ...
' numbers that are often set forth in
Wall Street
Wall Street is a street in the Financial District, Manhattan, Financial District of Lower Manhattan in New York City. It runs eight city blocks between Broadway (Manhattan), Broadway in the west and South Street (Manhattan), South Str ...
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, 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 conglomerate holding company headquartered in Omaha, Nebraska. Originally a textile manufacturer, the company transitioned into a conglomerate starting in 1965 under the management of c ...
*
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 ...
*
Cash flow forecasting
Cash flow forecasting is the process of obtaining an estimate of a company's future cash levels, and its financial position more generally. A cash flow forecast is a key financial management tool, both for large corporates, and for smaller entr ...
*
Valuation (finance)
In finance, valuation is the process of determining the value of a (potential) investment, asset, or security.
Generally, there are three approaches taken, namely discounted cashflow valuation, relative valuation, and contingent claim valuatio ...
*
Value investing
References
External links
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{{DEFAULTSORT:Owner Earnings
Berkshire Hathaway
Management accounting
Business terms
Valuation (finance)