Owner’s Earnings Formula For Stocks

Owner’s Earnings Formula

Calculating owner's earnings for stocks can help you determine the true value of a stock investment and not be swayed by short-term market fluctuations. Owners' earnings are calculated using a specific formula to measure the amount of money generated from an asset over time. Here is what you need to know about owners' earnings and how to calculate them for stocks.

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What is owner's earnings?

Owner's earnings are the amount of money a company or asset generates that would be available to owners after all expenses, including taxes and preferred dividends, have been paid. This figure provides a better indication of an asset's value than its mere market price. In addition, it helps investors understand how much cash flow is generated after all associated costs have been taken into account.

While other investors prefer to use metrics like eps, free cash flow per share, etc., Warren Buffet and Charlie Munger believe owner's earnings are a more accurate measure of a company's true worth. This is because owner's earnings are based on actual cash flow and not inflated by accruals or the estimation of future returns.

Owners earnings formula

The owner's earnings formula is pretty simple:

Owners earnings = net income + non-cash charges – maintenance capital expenditures (CapEx)

To calculate the owner's earnings for a stock, you will need to know the net income of the company, non-cash charges (like amortization and depreciation), and maintenance CAPEX. The maintenance CapEx refers to the amount of money a company spends to maintain its current operations, such as replacing machinery, purchasing software, and other business-related expenses necessary to remain competitive and generate profits.

By subtracting non-cash charges and maintenance CapEx from net income, you can calculate the owner's earnings and accurately measure the cash flow a company generates.

Simplified owners' earnings formula

The formula above can be simplified for stocks by replacing net income and non-cash charges with the operating cash flow. This is because operating cash flow includes both net income and non-cash charges, which can be found in the company's cash flow statement.

The simplified owner's earnings formula is as follows:

Owners earnings = operating cash flow – maintenance CapEx

The operating cash flow refers to the figure found on the company's cash flow statement, which shows how much money is generated from operations. Whereas maintenance CapEx refers to the capital a company spends to maintain its current operations, such as replacing equipment, software purchases, etc.

By subtracting maintenance CapEx from operating cash flow, you can get owner's earnings and determine a company's actual earnings, according to Warren Buffet.

How to calculate owner's earnings for stocks?

Let's look at a practical example, say you are considering investing in Apple Inc.

First, you need to calculate owner's earnings for Apple Inc.

To do this, locate the cash flow statement for Apple Inc and find the operating cash flow figure (it is usually listed as "cash Flow from Operating Activities"). As of 2022, this figure is $122.151 billion

Next, you need to subtract maintenance CapEx from the operating cash flow. Let's assume that this figure is $7.66 billion

Finally, you can calculate owners earnings by subtracting maintenance CapEx from operating cash flow:

Owners Earnings = Operating Cash Flow – Maintenance CapEx

Owners Earnings = $122.151 billion – $7.66 billion

Apple Inc owner's earnings = $114.491 billion

Therefore owner's earnings for Apple Inc, in this case, is $114.491 billion.

The key question here is how was the maintenance CapEx calculated.

Maintenance CapEx calculation

Method 1 all CapEx is maintenance CapEx

There are different ways of calculating the maintenance CapEx of a company. A common method is to assume that all CapEx is maintenance CapEx. This method is very conservative because most companies typically invest a percentage of their CapEx into initiatives to generate new economic benefits and maintain existing operations.

However, you can still apply this by simply looking at the company's cash flow statement and selecting the most recent CapEx value if it is available or calculate it using the following formula:

CapEx = net increase in property plant and equipment + depreciation and amortization

Method 2 Bruce Greenwald maintenance CapEx

The Bruce Greenwald method is the second method most typically used because it is more accurate. You can use this method by following the following steps developed by this famous professor, who is a renowned value investor and Professor at Columbia University:

  1. Calculate the average gross property, plant, and equipment (PP&E)/Sales ratio over 7 years.
  2. Calculate the current year's increase in sales.
  3. Multiply the PP&E/Sales ratio by the increase in sales to get growth CapEx
  4. Subtract the computed growth CapEx from the CapEx figure (in the cash flow statement) to get maintenance CapEx, which is the true depreciation for the company.

In practicality, you can see how on your spreadsheet, you can set up a template like this that calculates this value based on the steps above.

Bruce Greenwald maintenance CapEx spreadsheet

This template automatically sources the data on your Excel and Google Sheets spreadsheet from the Wisesheets add-on and performs the calculations automatically. You can get this template for free below, along with an owner's earnings template.

Owners earnings spreadsheet template

Instead of manually performing owner's earnings for every company you analyze, you can use this free template that retrieves the data you need for the calculation and performs all the calculations automatically.

Owners earnings spreadsheet template

The template gets the data using Wisesheets, so be sure to sign up for your free trial account so you can fully take advantage of it.

As you can see, the template allows you to perform this important calculation for any company you'd like across 50+ global exchanges worldwide. Better yet, it allows you to choose your preferred maintenance CapEx calculation method and provides the respective result.

Click here to download the free owner's earnings spreadsheet template.

How to use owner's earnings to value a stock

Now that you know how to calculate owner's earnings, you can use it to value the company.

The most common method of valuing a company using owner's earnings is the Price to owners earnings (POE) ratio. This metric compares the current market price of the stock with its owner's earnings to arrive at an indication of how expensive or inexpensive the stock is currently trading at:

POE Ratio = Price per share/ owners earnings per share

You can use this ratio to compare a company with its peers and also with its own history.

For example, if you have determined that a company's owner's earnings are $5 per share and currently trades at $50 per share, the Price to owners earnings ratio would be 10.

This means that for every dollar of owner's earnings, investors are paying $10. This can help you determine whether the company is undervalued or overvalued relative to its peers and its own history.

However, remember that these calculations are not foolproof and should only be used as a general indication of the company's value. Using Wisesheets, you can create tables like this that provide you with a more comprehensive set of price ratios to determine if a stock is overvalued or undervalued.

Graham number stock screener

Earnings vs owners earnings

It's important to note the difference between owner's earnings and normal accounting earnings.

Accounting earnings are affected by non-cash items like depreciation, amortization, and other one-time charges or gains. Whereas owner's earnings are a better measure of the true cash flow generated from operations because it excludes these non-cash items.

This makes owner's earnings a more reliable metric for valuing a company and making investment decisions.

For example, suppose a company shows a net income of $1 million but owner's earnings of only $500,000. In that case, it could be a sign that the company is not generating enough cash to sustain its operations and should therefore be avoided.

Limitations of using owner's earnings to value a stock

While owner's earnings is a useful metric for valuing stocks, it does have some limitations that investors should be aware of.

First and foremost owner's earnings does not consider the company's potential growth. If a company has low owner's earnings but is expected to grow rapidly in the near future, this may not be reflected in its owner's earnings.

Additionally, management decisions such as aggressive expansion can affect owner's earnings, which may not necessarily translate into immediate cash flow. This can lead to lower owner's earnings than they should be.

Finally, owner's earnings is only a measure of the company's past performance and does not indicate its future prospects. Therefore, investors should always use the owner's earnings in combination with other metrics, such as financial ratios and growth projections, when making investment decisions.

Technical Challenges and Common Mistakes in Calculating Owner's Earnings

Calculating owner's earnings for stocks is a valuable technique for assessing the intrinsic value of a company. However, it comes with its own set of technical challenges and common pitfalls that investors must navigate to ensure accurate analysis.

Technical Challenges

  1. Determining Maintenance CapEx: One of the most significant challenges in calculating owner's earnings is accurately determining the maintenance capital expenditures (CapEx). Differentiating between maintenance and growth CapEx can be complex, as not all companies clearly delineate these expenses in their financial reports.
  2. Fluctuations in Operating Cash Flow: The operating cash flow can vary significantly from year to year, influenced by factors such as changes in working capital, sales cycles, and other operational efficiencies or inefficiencies. This variability can make it difficult to accurately project future cash flows.
  3. Accounting Practices: Different accounting practices can affect the way figures are reported in financial statements, particularly concerning non-cash charges like depreciation and amortization. These differences can impact the calculation of owner's earnings and require careful adjustment and interpretation.
  4. Data Availability and Reliability: Accessing accurate and up-to-date financial data is crucial. However, investors may face challenges in sourcing reliable data, especially for private companies or smaller public companies with less stringent reporting requirements.

Common Mistakes

  1. Overlooking Non-Cash Expenses: Investors sometimes overlook or misunderstand the impact of non-cash expenses, such as depreciation and amortization, on the company's actual cash flow. This can lead to an overestimation of owner's earnings.
  2. Misinterpreting Maintenance CapEx: Misjudging what constitutes maintenance versus growth CapEx is a common error. This misinterpretation can significantly distort the calculation of owner's earnings, either inflating or understating the figure.
  3. Ignoring the Company's Growth Prospects: Solely focusing on current cash flows without considering the company's future growth prospects can lead to a skewed valuation. Owner's earnings should be a part of a broader analysis that includes growth potential.
  4. Relying on Single-Year Data: Basing the calculation on a single year's data can be misleading due to the cyclical nature of business and economic cycles. It's advisable to look at a multi-year trend to smooth out anomalies.
  5. Not Adjusting for Extraordinary Items: Failing to adjust for extraordinary items or one-time events can distort the true operating performance of a company. These items should be identified and excluded from the calculation to avoid skewed results.

Mitigating Challenges and Avoiding Mistakes

  1. Thorough Research and Analysis: Deep diving into the company's financial reports and understanding its business model can help in accurately identifying and categorizing CapEx and other relevant expenses.
  2. Using Multi-Year Averages: To mitigate the impact of annual fluctuations, use multi-year averages for operating cash flow and CapEx calculations.
  3. Staying Informed on Accounting Standards: Understanding and staying updated on accounting standards can help in correctly interpreting financial statements.
  4. Leveraging Financial Tools and Software: Utilizing financial tools like Wisesheets can simplify the calculation process and provide access to reliable data, while also allowing for customization and sensitivity analysis.
  5. Seeking Diverse Perspectives: Consulting with financial analysts or using multiple sources for data can provide a more rounded perspective and reduce the risk of bias or error.

By being aware of these technical challenges and common mistakes, and actively working to mitigate them, investors can more accurately assess the true value of a company through its owner's earnings. This approach, combined with a broader analysis of the company's financial health and growth prospects, can lead to more informed investment decisions.

Other Valuation Metrics

While owner's earnings provide valuable insight into a company's true cash flow, they are just one of many metrics used in stock valuation. Understanding a range of valuation metrics allows investors to form a more holistic view of a company's financial health and potential for growth. Here are some key valuation metrics that are commonly used alongside owner's earnings:

1. Price-to-Earnings (P/E) Ratio

  • Description: The P/E ratio compares a company's stock price to its earnings per share (EPS). It indicates how much investors are willing to pay for each dollar of earnings.
  • Usage: This metric is widely used for a quick appraisal of a company's relative valuation compared to its peers or the market average.

2. Earnings Per Share (EPS)

  • Description: EPS measures the portion of a company's profit allocated to each outstanding share of common stock. It's a direct indicator of a company's profitability.
  • Usage: Used in conjunction with the P/E ratio, it provides insights into a company's earnings trends and profitability.

3. Price-to-Book (P/B) Ratio

  • Description: The P/B ratio compares a company's market capitalization to its book value. It shows the value the market places on the company's equity relative to its actual net asset value.
  • Usage: Particularly useful for capital-intensive industries, like banking or manufacturing, where assets play a crucial role in operations.

4. Dividend Yield

  • Description: Dividend yield is the ratio of a company's annual dividend compared to its stock price. It shows how much a company pays out in dividends each year relative to its stock price.
  • Usage: Useful for income-focused investors who are interested in the company's ability to generate cash and return it to shareholders.

5. Return on Equity (ROE)

  • Description: ROE measures a company's profitability by revealing how much profit a company generates with the money shareholders have invested.
  • Usage: It is an indicator of financial performance, efficiency, and profitability from the shareholders' perspective.

6. Debt-to-Equity Ratio

  • Description: This ratio compares a company's total liabilities to its shareholder equity. It's a measure of the degree to which a company is financing its operations through debt versus wholly owned funds.
  • Usage: Important for assessing a company's financial leverage and risk.

7. Free Cash Flow (FCF)

  • Description: FCF represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. It's an indicator of a company's ability to generate additional revenues.
  • Usage: Used to assess profitability, dividends, and the potential for growth investments.

8. Enterprise Value (EV) to EBITDA

  • Description: This ratio compares a company's total value (enterprise value) to its earnings before interest, taxes, depreciation, and amortization (EBITDA). It is often used to determine a company's valuation in the event of an acquisition.
  • Usage: Useful for comparing the value of companies with different capital structures.

Conclusion

Owners' earnings is an important metric that investors should use to value a company. While it does have some limitations, owner's earnings can provide investors with an indication of the actual cash flow generated from operations and help inform their investment decisions. With Wisesheets, you can quickly and easily calculate owner's earnings and create tables to compare a company's performance with its peers.

By using owner's earnings in combination with other metrics and tools, investors can make more informed investment decisions.

To your investing success!

Hello! I'm a finance enthusiast who fell in love with the world of finance at 15, devouring Warren Buffet's books and streaming Berkshire Hathaway meetings like a true fan.

I started my career in the industry at one of Canada's largest REITs, where I honed my skills analyzing and facilitating over a billion dollars in commercial real estate deals.

My passion led me to the stock market, but I quickly found myself spending more time gathering data than analyzing companies.

That's when my team and I created Wisesheets, a tool designed to automate the stock data gathering process, with the ultimate goal of helping anyone quickly find good investment opportunities.

Today, I juggle improving Wisesheets and tending to my stock portfolio, which I like to think of as a garden of assets and dividends. My journey from a finance-loving teenager to a tech entrepreneur has been a thrilling ride, full of surprises and lessons.

I'm excited for what's next and look forward to sharing my passion for finance and investing with others!

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