Buffett in his 1986 letter to shareholders described how he worked out what he called the "owner earnings".
This is also referred to as the cash profits of a business.
Buffett believed the reported profits of a business were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.
How to calculate owner earnings or cash profits of a business?
Owner earnings are calculated as follows:
Owner earnings = net income
+ depreciation & amortisation
+ other non cash item
- maintainance capital expenditure.
Buffett's view was that the amount of money a company needed to spend to maintain its competitive position (known as maintainance, or stay in business, capex) often exceeded the depreciation and amortisation expense, and therefore profits were overstated.
Also, if a business needed extra working capital (more stocks, or more generous credit terms to customers), this should be added to the maintainance capex figure.
The difference between Owner Earning of Buffett and FCF
Generally speaking, in the owner earnings of Buffett or cash profits of a business, the calculation ignores changes in working capital that are included in free cash flow.
Hardest part of calculating owner earnings is estimating maintainance or stay in capex
The hardest part of this calculation is trying to estimate what maintainance or stay in business capex is.
As a company outsider without intimate knowledge of its assets and their condition it is virtually impossible for you to be exactly right on this.
But the good thing is, you don't need to.
The whole purpose is to get a figure for the amount of cash needed to keep fixed assets in good working order so that you can then have a conservative estimate of cash profits to value a company
Basing your valuation on a conservative figure is more prudent and lowers your changes of paying too much for a share, which in turn lowers your investment risk.
(Additional notes below)
What to do when the owner earnings or cash profits of a business are negative?
If you come across a company that looks as if it is losing money when estimating its cash profits you need to either
Summary:
In summary, here is what you need to do in calculating owner earnings or company's cash profits:
1. Take the company's most recent annual underlying or normalised net income/profit.
2. Add back depreciation and amortization.
3. Take away an estimate of stay in business capex.
4. Divide by the weighted average number of shares in issue for the latest financial year to get an estimate of cash profit per share.
Knowing a company's cash profits, we can use these to value shares.
Additional Notes:
How do you get an estimate of stay in or maintainance business capex?
There are 3 reasonable methods:
1. The company tells you.
Some companies are very good at simply stating what the figure is. They give this figure in their annual reports.
2. Use a multiple of the current depreciation or amortization expense.
Use a figure that is bigger than this, such as 120%. This can be a reasonable estimate, sometimes.
For some companies, it can be way off if the cost of replacing assets is falling.
3. Use a five or ten-year average of capital expenditure or capex.
This is likely to include money spent to grow a business but these assets will need to be replaced in the future and so this could provide a good proxy for cash needed to stay in business.
This is a good approach to use if the company does not state the figure outright.
This is also referred to as the cash profits of a business.
Buffett believed the reported profits of a business were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.
How to calculate owner earnings or cash profits of a business?
Owner earnings are calculated as follows:
Owner earnings = net income
+ depreciation & amortisation
+ other non cash item
- maintainance capital expenditure.
Buffett's view was that the amount of money a company needed to spend to maintain its competitive position (known as maintainance, or stay in business, capex) often exceeded the depreciation and amortisation expense, and therefore profits were overstated.
Also, if a business needed extra working capital (more stocks, or more generous credit terms to customers), this should be added to the maintainance capex figure.
The difference between Owner Earning of Buffett and FCF
Generally speaking, in the owner earnings of Buffett or cash profits of a business, the calculation ignores changes in working capital that are included in free cash flow.
Hardest part of calculating owner earnings is estimating maintainance or stay in capex
The hardest part of this calculation is trying to estimate what maintainance or stay in business capex is.
As a company outsider without intimate knowledge of its assets and their condition it is virtually impossible for you to be exactly right on this.
But the good thing is, you don't need to.
The whole purpose is to get a figure for the amount of cash needed to keep fixed assets in good working order so that you can then have a conservative estimate of cash profits to value a company
Basing your valuation on a conservative figure is more prudent and lowers your changes of paying too much for a share, which in turn lowers your investment risk.
(Additional notes below)
What to do when the owner earnings or cash profits of a business are negative?
If you come across a company that looks as if it is losing money when estimating its cash profits you need to either
- do some more research to see if you have missed something - such as the company investing in lots of new assets rather than replacing them - or
- look for another share to buy.
In summary, here is what you need to do in calculating owner earnings or company's cash profits:
1. Take the company's most recent annual underlying or normalised net income/profit.
2. Add back depreciation and amortization.
3. Take away an estimate of stay in business capex.
4. Divide by the weighted average number of shares in issue for the latest financial year to get an estimate of cash profit per share.
Knowing a company's cash profits, we can use these to value shares.
Additional Notes:
How do you get an estimate of stay in or maintainance business capex?
There are 3 reasonable methods:
1. The company tells you.
Some companies are very good at simply stating what the figure is. They give this figure in their annual reports.
2. Use a multiple of the current depreciation or amortization expense.
Use a figure that is bigger than this, such as 120%. This can be a reasonable estimate, sometimes.
For some companies, it can be way off if the cost of replacing assets is falling.
3. Use a five or ten-year average of capital expenditure or capex.
This is likely to include money spent to grow a business but these assets will need to be replaced in the future and so this could provide a good proxy for cash needed to stay in business.
This is a good approach to use if the company does not state the figure outright.
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