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Both earnings per share (EPS) and cash flow have serious deficiencies in business valuation. Earnings per share was briefly mentioned in the previous article on return on assets, its problem being that in times of inflation, companies with a low return on assets suffer as the replacement cost of these assets increases. A better way of assessing earnings would be to look at actual cash flow.But cash flow has problems of its own, as it is invalid to compare the cash flow of a company requiring high capital expenditure with one with low capex. Cash flow works fine when a company has little need for large ongoing outlays past initial setup costs, such as real estate companies, cable and telco companies and oil and gas industries. However cash flow is a poor measure of the worth of companies that require extensive ongoing capital expenditure, such as manufacturers and airlines.”Owner earnings” is a concept invented by Warren Buffet that overcomes the capex deficiency of cash flow. You add back to earnings the deductions made for depreciation etc and subtract off capital expenditures. Owner earnings is calculated as:Owner earnings = net income + depreciation + depletion + amortization – capital expenditures – additional working capital
Admittedly it isn’t a precise measure, it requires the analyst to make an estimation of upcoming capital expenditures, which can be a fairly approximate excercise, however this is probably the best anyone can do. The answer is going to be approximately right, rather than exactly wrong.
