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The Principle of Owner Earnings when Investing

11 June 2008 - Markets - Editor

Good investors are constantly on the look out for metrics that can assist them in their assessment of the true worth of a company that they may be considering investing in. With hindsight being the only exact science, investing often comes down to making an educated guess. There are, however, a number of ways to minimize the guesswork when making investment decisions. One of these is making use of the principle of “owner earnings”.

Investment mogul, Warren Buffet, has referred to the owner earnings of a company as being the true measure of the company’s earnings. The owner earnings of a company is the company’s reported earnings, plus depreciation, plus amortization, plus depletion, less the average annual amount of capitalized expenditure for plant, machinery and equipment which is essential to the company maintaining its competitive position in the long-term.

Depreciation is generally a pre-determined, fixed percentage of an amount spent in the past on fixed assets. This is not necessarily a true reflection of the future replacement cost of these items once they have become obsolete. It is standard practice in many companies to include in accounting amortization things such as economic goodwill, being brand name, market dominance, and reputation. However there is the likelihood that, rather than depreciating, these may actually increase in value over time. Annual capital expenditure is difficult to estimate as items may be deferred to the following financial year, or may be brought forward, therefore, averaging actual expenditure over a number of years is a more reliable guide of the true capital needs of a company.

Although Wall Street reports state company cash flow numbers these are not necessarily a true reflection of the company’s financial situation. Cash flow takes into account the company’s earning and depreciation, depletion and amortization, but does not allow for the deduction of capitalized expenditure necessary to maintain market position.

The owner earnings principle allows investors to take a look the assets that form a company’s foundation, as well as its ability to generate excess cash. Many investors have found this to be a very effective tool, especially when investigating the investment potential in undervalued companies. Although owner earnings, as with most aspects of investing, is not fool-proof, it does facilitate a clearer picture of a company’s operations.

 


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