In 1986, Warren Buffett detailed his valuation method. He stated that the value of a company is simply the total of the net cash flows expected to occur over the life of the business, discounted by an appropriate interest rate.
Rather than using Wall Street earnings numbers for valuing a business, Warren Buffett stated that he prefers to use what he calls Owner Earnings. He defined owner earnings as follows:
- "These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges...less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume....Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes...All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) - but do not subtract (c)."
- Buffett, Warren E. (February 27, 1987). "1986 Letter to Shareholders". Berkshire Hathaway, Inc. Retrieved 2007-05-22.