Owner earnings
Encyclopedia
In 1986, Warren Buffett
detailed his valuation
method. He stated that the value of a company
is simply the total of the net cash flow
s (owner earnings) expected to occur over the life of the business, discounted by an appropriate interest rate
.
He defined owner earnings as follows:
Warren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
detailed his valuation
Valuation (finance)
In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets or on liabilities...
method. He stated that the value of a company
Enterprise value
Enterprise value , Total enterprise value , or Firm value is an economic measure reflecting the market value of a whole business. It is a sum of claims of all the security-holders: debtholders, preferred shareholders, minority shareholders, common equity holders, and others...
is simply the total of the net cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
s (owner earnings) expected to occur over the life of the business, discounted by an appropriate interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
.
He defined owner earnings as follows:
- "These represent (a) reported earningsEarningsEarnings 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 used as EBIT -- earnings before interest and taxes, EBITDA - earnings before...
plus (b) depreciationDepreciationDepreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
, depletion, amortizationAmortization (business)In business, amortization refers to spreading payments over multiple periods. The term is used for two separate processes: amortization of loans and amortization of intangible assets.-Amortization of loans:...
, and certain other non-cash charges...less (c) the average annual amount of capitalized expendituresCapital expenditureCapital expenditures are expenditures creating future benefits. A capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life extending beyond the taxable year...
for plant and equipmentFixed assetFixed assets, also known as a non-current asset or as property, plant, and equipment , is a term used in accounting for assets and property which cannot easily be converted into cash. This can be compared with current assets such as cash or bank accounts, which are described as liquid assets...
, 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 GAAPGaapIn demonology, Gaap is a mighty Prince and Great President of Hell, commanding sixty-six legions of demons. He is, according to The Lesser Key of Solomon, the king and prince of the southern region of Hell and Earth, and according to the Pseudomonarchia Daemonum the king of the western region and...
, 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 flowCash flowCash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
' numbers that are often set forth in Wall StreetWall StreetWall Street refers to the financial district of New York City, named after and centered on the eight-block-long street running from Broadway to South Street on the East River in Lower Manhattan. Over time, the term has become a metonym for the financial markets of the United States as a whole, or...
reports. These numbers routinely include (a) plus (b) - but do not subtract (c)."