Add Back Depreciation To Free Cash Flow Because It What Is Warren Buffett’s "Owners Earnings"?

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What Is Warren Buffett’s "Owners Earnings"?

Warren Buffett, the mastermind of the investment world, believes that “earnings to owners” is the true measure of a company’s valuation. They believe that a company’s free cash flow determines the wealth that is paid to the organization’s shareholders who actually own the company. The owner’s earnings can be calculated from the following formula:

Owners’ earnings = Net income + Depreciation and amortization – Capital investment – Additional working capital requirements.

Investors familiar with the concept of financial leverage will notice that Warren Buffett’s formula is based on calculating free cash flow from investments. But what exactly is the reason behind this equation? To begin with, net income is an accrual based calculation that considers cash and non-cash items; Therefore, depreciation and amortization, both of which are non-cash items, must be added back to earnings to arrive at an income that reflects the net cash flow from the organization’s operating activities. Buffett considers depreciation to be a historical expense that should not be included in the calculation of net income. Furthermore, he argues that amortization of goods such as goodwill is unreasonable. Because the company’s goodwill is likely to increase over time rather than decrease.

The next item in the equation is capital expenditure which does not form part of net income on the income statement. Instead a fixed percentage of capital expenditure is deducted from gross profit known as depreciation to arrive at net income. Warren Buffet states that the actual capital expenditure incurred during the year must be subtracted from the net income so that the investor can calculate the true value of the free cash flow generated after deducting all expenses including capital expenditure. . This is because capital expenditures have generated sales for a given year and must be deducted to reflect the true net income for the given year.

Similarly, the organization’s working capital needs must be calculated by determining the net change in each component of the working capital cycle—debtors, debtors, and stock. The net change in working capital must be reflected in the owner’s income. If working capital requirements have increased, the net effect must be subtracted and if they have decreased, the net effect must be added back to net income.

The end result of the calculation is the generation of free cash flow credited to the organization’s owners that can either be reinvested or used to pay dividends to shareholders. Owner’s earnings, in short, are net earnings that take into account all investing activities and add back all non-cash items to net income. The final answer reflects the firm’s ability to generate cash from the investments made by shareholders in terms of equity.

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