Saturday, 25 February 2012
Owner Earnings or Free Cash Flow
Warren Buffett has referred to the ‘owner earnings’ of a company as the true measure of earnings.
He has defined ‘owner earnings’ as:
+ depreciation, amortization, other non-cash items
- average annual amount of capitalized spending on plant, machinery, equipment (and presumably research and development).
His thinking seems to go like this.
You should not consider depreciation because this is generally a fixed percentage of an amount spent in the past that does not necessarily reflect the true cost of replacing things when they are obsolete.
Buffett has often criticised accounting amortisation of things such as economic goodwill. Economic goodwill, including things such as brand name, reputation, monopolistic or market dominance, might actually increase in value rather than depreciate.
It is difficult to estimate true capital spending. Items may be deferred or brought forward. Averaging actual expenditure is a more reliable guide of a company’s true capital needs.