Warren Buffett, the mastermind of the investment world, believes that “owners’ earnings” are a true measure of a company’s valuation. Consider that the free cash flows of the business determine the wealth attributable to the organization’s shareholders who are actually the owners of the business. Owner’s earnings can be calculated with 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 the Warren Buffets formula is based on calculating the 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 operating activities of the organization. Buffett views depreciation as a historical cost that should not be incorporated into the calculation of net income. In addition, it maintains that the amortization of items such as goodwill is not realistic. This is because the company’s goodwill is likely to increase over time rather than decrease.
The next element in the equation is the capital expenditure that is not part of the 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 profit. Warren Buffett states that the actual capital expenditure that has taken place in the year must be subtracted from net income so that an investor can calculate the true 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 the generation of sales for the given year and must be deducted to reflect the actual 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, that is, creditors, debtors, and stocks. Net changes in working capital should be reflected in the 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 final result of the calculation is the generation of free cash flows attributable to the owners of the organization, which 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 ability of the company to generate cash from the investment made by the shareholders in terms of capital.