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.
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:
- Calculate the average gross property, plant, and equipment (PP&E)/Sales ratio over 7 years.
- Calculate the current year's increase in sales.
- Multiply the PP&E/Sales ratio by the increase in sales to get growth CapEx
- 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.
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.
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.
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.
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!