In this lesson, students learn the difference between accounting earnings and Warren Buffett's Owner's Earnings.
When an Investor looks at the bottom line figure on the Income Statement, they find the Net Income. This is the profit the company has produced for the given time frame. Although many use the net income to value a business, Warren Buffett takes a different approach, and calculates what he calls the Owner's Earnings.
In order to understand the concept of Owner's Earnings, one must understand the two paths that the Net Income takes after it's produced. The first path is a potential dividend payment. Any funds that take this path are immediately valued as Owner's Earnings. The remain amount of net income after the dividend payment is then used to invest back into the business. This money also has two paths. This money can be used to reinvest into the maintenance and care of the already existing equipment, or it can be spent expanding the assets of the company. If the funds flow in the first direction, called Capital Expenditures, little to no growth in the company's book value will occur. If the funds flow in the second direction, the money will add new streams of income to the business and the asset will be added to the current equity of the business. This second amount is added to the dividend and the total is referred to as the Owner's Earnings.
If a person would be interested in calculating the owner's Earnings, they could simply take the funds from the Operating Activities section on the Cash Flow Statement, and subtract it from the Capital Expenditures -- also found on the Cash Flow Statement.
Remember the true Owner's Earnings is nothing more than the book value growth and the dividends combined.