Owner Earnings = No Sleep

Posted: 11 Nov 2007 03:07
Registered User Currently Offline	Posts: 1 Join Date: Nov 2007
What is the calculation for owner earnings? I have spent the last 48 hours pouring over Buffett's 1986 letter to shareholders and every website that so much as mentions the name Warren Buffett and I am still unsure. In the letter it is spelled out as, "(a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N's items (1) and (4) less (c) the average annual amount of capitalized expenditures for plant and equipment, etc..." My problem is items 1 and 4! For a long time I have interpreted 1 and 4 to mean other non-cash items and changes in working capital. The resulting calculation is basically cash flow from operations (as shown on any cash flow statement) minus cap-ex. Am I wrong to include all changes in working capital, deferred taxes, and other non-cash items? The letter can be found here, near the bottom: http://www.berkshirehathaway.com/letters/1986.html Please help, I need some sleep.

Posted: 29 Nov 2007 13:21
Registered User Currently Offline	Posts: 16 Join Date: Feb 2007
dah7783, I believe you're spot on with this assessment. However, the reason for Graham and Buffett referring to owners' earnings and not change in working capital (operating cash flow) is exactly because of item (c). A lot of investors will ordinarily follow the operating cash flow as the cleanest earnings, believing this to be free from manipulation and accounting smoke 'n mirror gimmickry. Annual expenditure falls in the second section of the cash flow statement as investment activities. But this minimum level of investment will always have to occur and should be considered as part of an above the line expenditure and thus subtracted from the gross revenue. It is as if it were the minimum effort required to empty out water filling a leaky fishing boat in order not to sink any further. It adds nothing but prevents a whole lot of calamity. This minimum level of "investment" also plays havoc with trying to discern the "one dollar premise". This year's revenue hasn't necessarily increased along with the retained portion of last year's income apportioned to annual capitalization. In fact the revenue has remained exactly the same (excluding inflationary adjustment of course). So above this minimum level, every marginal extra dollar spent on useful investment has to work a little harder to make up the ground that the initial investment failed to make to make sure that for every dollar retained = a dollar extra value. Even though your interpretation of the deferred taxes, as a non-cash charge, seems to be correct, personally I would feel more comfortable in leaving them as a charge against the revenue - the cash apportioned to deferred taxes may in fact be able to be extracted from the business and it may be useful as creating a bit of investment float while waiting to be paid to the IRS, but it does not belong to the owners. Much rambling, sorry. Scarborough