How Warren Buffett Calculates ROE

Warren Buffett's annual letters to the shareholders of Berkshire Hathaway are treasured by legions of his fans. These letters provide an insight into how the Oracle of Omaha goes about doing his investments. The letters also unravel his thinking process and his critical analysis of the wrong decisions he has made during the course of the year or sometimes in his investing life. Many investors, who also include some very big names in the Indian stock market, read his letters repeatedly in search of undiscovered gems in them.

His 1986 annual letter had one such gem which, many investors believe, offers a glimpse of Buffett's unique thinking. In the letter Buffett explained why he does not go by the net profit mentioned in the income statement. He rather uses a slightly modified concept, which he calls owner earnings.

In simple terms, this is what Buffett referred to as owner earnings:

Owner earnings = Net income + Depreciation and Amortisation - Capital expenditures

One can get net income and depreciation figures from the profit and loss statement. Capital expenditure can be sourced from the cash flow statement under the 'cash flow from investing activities' column.

Why the modified formula?
The whole idea behind owner earnings is to figure out how much cash falls into the owners' pockets. That is the reason why Buffett calls it owner earnings. He likes to look at the real amount an owner receives from his business.

Any business manager will tell you they need to spend something more than depreciation and amortisation on their businesses over a long period to hold onto the volume and competitive position. Against this backdrop, where the capital expenditure is greater than depreciation, accounting conventions overstate earnings.

Basically, Buffett is dismissing cash flow numbers in Wall Street reports, where operating cash flows are shown as net profit plus depreciation and amortisation, without subtracting the capital expenditure. Cash flow is meaningless in businesses like manufacturing, retail, extractive companies and utilities. This is because these companies always have huge capital expenditure.

However, owner earnings are not needed for business that make huge capital outlay initially and small outlays thereafter. Cash flow works in these businesses.

We have applied this formula to the Nifty companies and the BSE 100 companies. We used owner earnings to calculate the return on equity. There were some interesting results. For example, there is a wide difference between the actual ROE and the one derived from the Warren Buffett formula in the case of Hero MotoCorp, with Buffett's approach showing a higher ROE. The situation is reverse in the case of Tata Motors. See the table below for other findings.