What is the business owner really earning
Owner earnings formula
Warren Buffett, the great investor, explained in one of his letters to him shareholders what he considered to be "owner earnings". His formula suggested that you should take the earning of the company, add back depreciation and amortisation charges, plus any non-cash items, minus long term required capital expenditure.
The Buffett owner earnings formula makes a lot of sense. It is attempting to figure out how much of the Company's earnings should go to shareholders assuming no reinvestment. It's a required formula as often times accounting policies can mask the true nature of a company's earnings.
The owner earnings formula asks a simple question: if the owner of the business were to withdraw from the business his full profit entitlement each year, what would they get. One might suggest, that simply it should be all the cash on the business. However, accounting rules have rather muddied the waters on retained earnings within the business that the business owner is entitled to versus cash.
What does the bank get?
Most businesses have an element of bank funding. The owner earnings formula already takes into account the share of the company's profits that the bank is entitled to. The bank receives its share of the profits generated from a business via its charging of interest.
The "earnings" part of the formula is after interest on any debt or borrowings within the business. As such, the bank has already earned its share. The same is true of the governement via the corporation tax mechanism.
Why is depreciation and amortisation added back?
Depreciation and amortisation are 'made up' costs within a business resulting from accounting treatments rather than any actual expenses paid out. If a business is using a building or piece of machinery it has normally paid for the item in full upon receiving use of the item (normally funded with bank borrowings). The depreciation or amortisation charge is simply a way of sharing that initial cost of the property or machine over the life of the asset.
The adding back of depreciation and amortisation to owner earnings is to get back to an earnings figure that's more in line with cash today. In reality, the depreciation charge has not diminished cash within the business. It is added back to earnings to remove the non-cash related charge. Similarly, other non-cash items are added back to earnings.
Removal of long term capital expenditure
The final part of the owner earnings equation is to deduct a long term capital expenditure requirement of the business. This may appear odd upon initial understanding. Why not simply keep the depreciation charge which reflects the cost related to capital expenditure.
The removal of long term own earnings asks the following question: what capital spending was required in order to get to the current year profits? Clearly some machines are in regular need of repair and maintenance. Hence, the charge must be added back to reflect the true cost base to reach the owner earnings.
In reality, capital expenditure is much higher than this capital maintenance charge. This is because some of the owner earnings are being used to fund future growth by investment or buying new machinery etc. The combination of adding back the depreciation charge but still charging a maintenance capital cost reflects the actual earnings that the business owner is entitled to, assuming no reinvestment takes place during the year.