Company's Financial Accounting
Price to Owner Earnings Ratio
Owner Earnings: Warren Buffett's Favorite Valuation Method
DEFINITION:
Price-to-owner-earnings ratio (P/OE) is a comparable indicator to Price-to-earnings (P/E) ratio. Nevertheless, it can be said that P/OE ratio is a more accurate version of the standard P/E with the following difference:
- earnings (E) used in P/E ratio is reported earnings in compliance with GAAP (Generally Accepted Accounting Principles);
- whereas, owner earnings (OE) are realistic cash earnings, that gives better picture of a company’s profitability.
What is owner earnings? It is the cash generated from operations of the business subtracted by the capital expenditures required to maintain the existing business.
Owner’s earnings. Key points:
- helps to determine the cash flow of a company, Free cash flow;
- better represents the true earnings of a company;
- shows how much cash one can get out of an investment;
- helps to ascertain what are the real owner's earnings compared to the accounting earnings;
- is being used owner earnings instead of reported net income (earnings);
- used in a long-term approach centering in fundamentals of the business rather than in short-term earnings that can been easily manipulated;
- Warren Buffett's favorite formula and approach.
FORMULA for calculations:
PRICE-TO-OWNER-EARNINGS = Share Price / Owner Earnings per Share
OWNER-EARNINGS-PER-SHARE = (Net Income + Depreciation, Depletion and Amortization + Change In Deferred Tax -
- 5Y Average of Maintenance Capital Expenditure + Change In Working Capital) / Shares Outstanding
OWNER EARNINGS = Reported earnings (or Net Income) + Depreciation, Amortization +/- Other Non-cash Charges -
– Average Annual Maintenance CAPEX +/- Changes in Working Capital
The data for calculations can be found:
- Reported earnings or Net Income (income statement).
- Depreciation, Depletion, and Amortization (cash flow statement).
- Other non-cash charges (cash flow statement; usually include "Stock Based Compensation" and "Change In Deferred Tax").
- Maintenance Capital Expenditure or Total capital expenditures (cash flow statement) - average annual amount of capitalized expenditures for plant and equipment, etc.
Note: maintenance CAPEX can be difficult to calculate accurately. - Working Capital = company's current assets - current liabilities (balance sheet). If Working Capital is:
- negative, i.e. current liabilities are greater than current assets; it means the company needs more capital to grow, and this in turn reduces cash flow as well as owner earnings;
- positive, i.e. business has sufficient liquid assets to pay off immediate debts; company has more money to reinvest and grow, this increases cash flow as well as owner earnings. - Changes in Working Capital- difference in amount from one accounting period to the next.
- If there is an increase in working capital then it has to be deducted from the owner's earnings as the business need more money to keep it as is.
- Negative working capital means there is no change and it is no need to account for that.
The simplified Buffett's FORMULA:
OWNER EARNINGS = Operating cash flow of a business - Maintenance capital expenditures
- where:
- Operating cash flow (OCF): Cash generated from the company's normal business operations.
- Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital.
RESULT INTERPRETATION:
-
Owners’ earnings:
- negative - means the amount of money the business is losing for its owners per year;
- positive - means the amount of money the business bringing in for its owners per year.
As P/OE ratio is a version of the standard P/E, please find: P/E RATIO'S RESULT INTERPRETATION AND EXAMPLE to analyze the result.
FIND MORE:
Fundamental Analysis Indicators