Owner Earnings or Free Cash Flow

WARREN BUFFETT ON OWNER EARNINGS

Warren Buffett has referred to the ‘owner earnings’ of a company as the true measure of earnings. 

He has defined ‘owner earnings’ as:

Reported earnings 

+ depreciation, amortization, other non-cash items

 - average annual amount of capitalized spending on plant, machinery, equipment (and presumably research and development).

REASONING BEHIND OWNER EARNINGS

His thinking seems to go like this.

Depreciation

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.

Amortization

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.

Capital expenditure

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.