Owner earnings is different from the company’s earnings. In this post, I will explain what is Owner earnings of a company and teach how to calculate the owner’s earnings. It’s a long post please get a cup of coffee and read full.
Owner earnings is a valuation method detailed by Warren Buffet in Berkshire Hathaway’s annual report in 1986. He stated that the value of a company is simply the total of the net cash flows (owner earnings) expected to occur over the life of the business, minus any reinvestment of earnings.
Here is the 1986 annual report:
https://www.berkshirehathaway.com/letters/1986.html
Let me explain this in simple language with an example.
In India, one business that cannot fail is selling tea/coffee in a good location.
Imagine that you want to start a business and find a shop in a good location. You finalize a 10 years lease for renting the property. We assume it is ₹20,000.00 a month (expenditure).
You design the interiors of the shop. For this about ₹500,000.00 was spent (expenditure).
You now have to spend money to buy a gas stove, utensils, cups and plates, coffee roasters, espresso machines, etc. For this about ₹200,000.00 was spent. Form now we assume that ₹2 lakh will have to be spent every 2 years for repairs and buying new utensils (expenditure).
Please note that the money spent on interiors was permanent but the machines and utensils will need regular expenditure like repairs, buying new utensils etc. So rent, repairs, utensils fall under recurring expenditure.
Your restaurant now looks good and is ready to take customers.
But wait there are more expenditures left. They are coffee beans, tea leaves, milk, sugar, water, napkins, paper cups, etc. For this expenditure is approx. ₹25,000 a month. Please note that this is a recurring expenditure. This can vary between 20 to 30k a month. So I have taken an average of ₹25,000 a month.
Finally, on Apr 01, 2020, you open the restaurant for customers.
Nice location, good quality tea/coffee resulted in the huge success of your restaurant.
Fast forward to Mar 31, 2021. One year passed since you opened the restaurant.
We assume your revenue collected was ₹24,00,000.00 (24 lakh or 2 lakh a month or ₹6666.66 per day tea/coffee+sandwiches sold per day) in the first year of business. Here is some calculation that this is possible. To get a revenue of ₹6666.66 per day you have to get just 50 customers a day with an average bill of ₹134.00. 134 * 50 = 6700. If your restaurant is open 12 hours a day from 9 am to 9 pm then to get 50 customers all you want is 4 customers on an average per hour. 50/12 = 4.1. With just 4 customers per hour, your revenue collected was ₹24,00,000.00. Calculate yourself revenue collected if 5 customers come per hour. TIP: If you want to start a business this is a great idea.
Now it’s time to calculate the profits to pay taxes.
Revenue: ₹24,00,000.00
Expenditure first year:
Rent: 20,000 * 12 = ₹240,000.00
Interior Design (including furniture): ₹500,000.00 (This will not be included from the second year of business)
Recurring expenditure for utensils, cups and plates: 8,000 (a month) * 12 = ₹100,000.00 (added 4000 to make it whole figure)
Recurring expenditure to make coffee/tea: 25,000 * 12 = ₹300,000.00
Salary for helper to make coffee and taking care of the business: 25,000 * 12 = ₹300,000.00
Total expenditure: 240000 + 500000 + 100000 + 300000 + 300000 = ₹14,40,000.00 (14 Lakh 40 Thousand)
Profit first year of business: 2400000 – 1440000 = ₹960,000.00 (Nine Lakh Sixty Thousand)
Note that from second year of business profit will increase to 960000 + 500000 (interior design one time expenditure) = ₹14,60,000.00 or more/less.
Calculating the first-year tax as per Income Tax Slabs & Rates of FY 2020-21:
Your income tax slab is between ₹7,50,001 – ₹ 10,00,000.
This you need to pay:
₹37500 + 15% of total income exceeding ₹7,50,000
960,000 – 750,000 = 210000 * 15% = ₹31,500.00
Final tax: 37500 + 31500 = ₹69,000.00
So the profit after tax in the first year (FY 2020-21) is:
960,000.00 – 69,000.00 = ₹891,000.00 (Approx. ₹74,250 per month)
You keep this money in a nearby SBI checking account.
Now, this account already had some cash before you opened an account. Assuming it was ₹500,000.00
So you will think that after paying taxes on 01-Apr-21, this account will have 891,000 + 500,000 = ₹13,91,000.00? Right?
NO!!!
Why? Because a lot of deposits and withdrawals were made during the FY 20-21. Some withdrawals were unexpected but required to run the business.
Deposits made is equal to revenue (all the cash collected from customers): ₹24,00,000.00
Withdrawals made are equal to expenditure: ₹14,40,000.00
So final balance remaining:
500000 + 2400000 – 1440000 – 69000 – 100000 = ₹12,91,000.00
You must be thinking from where in the expenditure 100000 came from?
These are unexpected expenditures that every business has to face. This may include but not limited to repairs that were supposed to be done once in 3 years, coffee bought at a higher price due to non-availability of coffee that was regularly used in the shop, lawyer fee for any legal issue, wear and tear of interiors, wear and tear of furniture, coffee making equipment, etc.
This extra expenditure can sometimes be huge and needs to be managed. It’s called depreciation.
Depreciation is unknown, however, CAs allocates the cost of a tangible or physical asset over its useful life or life expectancy. Depreciation represents how much of an asset’s value has been used up. Depreciation comes under expenditure and the company does take the benefit of taxes on them.
Note that depreciation is not fixed, it keeps varying from year to year.
So what did you learn?
In the first year of business, your net income will be less and subsequently increase over the years.
For example, FlipKart.com started in October 2007 took several years to just breakeven:
https://www.livemint.com/Companies/xRKMBufiZd8XSyn0ZbuZzM/Flipkart-aims-to-break-even-this-year-by-paring-discounts-o.html
Overhead expenditures are a major issue for big businesses. Owners cannot even know what kind of unexpected expenditure may occur in future, so big business keeps some percentage of the revenue separately for unexpected expenditures.
Here we have taken the example of a simple shop kind of business where not much monitoring is required for overhead expenditures but for big businesses, if not managed well, these unexpected/overhead expenses can lead to the fall of a business.
Here is one big company that failed partly due to this reason and other reasons. Lehman Brothers Collapse:
In 2008, it had $639 billion in assets, technically more than enough to cover its $613 billion in debt. However, the assets were difficult to sell. 5 As a result, Lehman Brothers couldn’t sell them to raise sufficient funds. That cash flow problem is what led to its bankruptcy.
Source: https://www.thebalance.com/lehman-brothers-collapse-causes-impact-4842338
So if you too want to start a business you must learn the difference between “net income” and “operating cash flow”. Operating cash flow must include unexpected expenditures. Operating cash flow is the life of a business. Without sufficient operating cash flow, a business will collapse.
Now another question:
You started this business to make money to run your family right?
So how much can you withdraw from ₹12,91,000.00 in that year for your own personal expenditures? Please note that you cannot withdraw 100% as this will finish the business. Withdrawing even 90% can hurt the business.
This is what you can withdraw:
As a thumb rule, you can withdraw any amount over and above 3-4 months of “operating cash flow” which must include an average of 3 months of normal expenditure.
And you must also include inflation in mind. Say for example if in 2020 your 3 months operating cash flow is 100,000.00 then in 2021 it will be 105,000.00.
It does not end here. Remember every two years there is expenditure on buying new parts/entire machine to make coffee. Now what you spent in 2020 to get the same machines will cost more, about 10% more.
This must be included in the operating cash flow which you cannot withdraw.
10% of 3 lakh is 330,000. So you have to keep at least a third of this in the operating cash flow because this expense may come anytime.
Do not forget that you may need 50% of the money that you spent on furniture every 10 years. This is for changing or replacing the damaged furniture.
Or you may want to change the entire furniture and replace them with better-looking ones in a few years time especially if your business has grown. This will be a major expense. You must have noticed in one of your favourite restaurants suddenly one day that they have changed all the furniture.
This expense maybe 20% more than what you spent for the first time.
Since you may need this money in 10 years’ time, you have to calculate and keep this amount too in the operating cash flow. If you will not keep it now then in the 10th year you may find it difficult to manage the cash flow.
Now coming back to your account. It has ₹13,91,000.00.
Note that now when you want to withdraw you have entered the second year of business where you are likely to make ₹14,60,000.00.
We assume every month expenditure * 3 months plus other overhead operating cash flow and future expenditures comes to ₹144,000.00. So 144000 * 3 = ₹4,32,000.00
So you can withdraw: 1391000 – 432000 = ₹959,000.00
₹959,000.00 is the Owners Earnings
What do you conclude from this?
That money lying with the bank of the company is not what is “owned” by the owners. What matters for the owner is how much cash they can withdraw from this account for personal use without hurting the business in the short as well in the long term.
Lesson learned:
If you plan to buy a stock you must think like an owner. You should see the financials especially the debt of the company. Try to figure out how much the company can give dividends without disturbing their business.
And currently what you are paying to get one stock. Does that make sense?
Conclusion:
Owners earnings is not the net income of the company, not the profit of the company but it’s the total money lying with the company minus debts if any minus money needed to run the company for the next few months i.e “operating cash flow”. For big companies, it has to be the next few years and for small it’s the next few months. For a small shop that you see in your area Owners earning (shopkeeper’s earning) for one month is total revenue made minus expenditures to buy products for the next one month minus bills to be paid like electricity minus three months of cash reserved as a deposit to run the shop.
I hope you can understand that finding out the exact owners earnings is not possible but the owner can get an approximate figure based on the above-written points and take out the money to his/her personal account.
With that, I end this long article and hope you have understood how to calculate the owner’s earnings.
If you want to add/ask something do write in the comments section below.
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