By Maksym Lytvynov, Founder of AlphaStocks | Last updated: 2026-09-23
Buffett Quality Investing: Owner Earnings, Moats, and ROE
Warren Buffett wrote down how he judges a business in his letters to Berkshire Hathaway shareholders: by the return it earns on equity year after year, by the cash it produces for its owners, by how little it needs to borrow, and by whether each dollar it keeps turns into more than a dollar of market value. AlphaStocks turns those tests into pass/fail criteria computed from ten years of annual SEC filings, and uses them as one of the two models on the Quality axis.
What Are Owner Earnings?
In his 1986 letter, Buffett introduced owner earnings as a more honest measure of what a business earns for its owners than reported net income: reported earnings, plus depreciation and amortization, less the capital spending the business needs to keep its position.
Owner Earnings = Net Income + D&A − CapExNet Income (NI)
The starting point — bottom-line profit as reported on the income statement.
Depreciation & Amortization (D&A)
Added back because it is a non-cash charge. The cash was spent when the asset was bought.
Stock-Based Compensation (SBC)
Not added back. Buffett's 1992 letter asks: if options are not compensation, what are they? AlphaStocks leaves stock pay as the expense it is, so a company that pays its staff in shares does not look more profitable for it.
Capital Expenditures (CapEx)
Subtracted because this is real cash the business must spend to maintain its productive capacity. Filings do not split maintenance from growth spending, so all of it is subtracted — the conservative reading.
The model's owner-earnings criterion: owner earnings (net income + D&A − capex; stock pay stays an expense) positive every year, and the latest 3-year average above the first. Owner earnings also drive the debt test (total debt ≤ 3 × owner earnings, and equity positive) and the intrinsic value behind the margin-of-safety test (price ≤ 75% of intrinsic value (owner earnings per share, 10 years at the company's own growth held to -5%…10%, then 3% forever, discounted at 10%)).
Why ROE Consistency Matters More Than ROE Level
A single strong year of return on equity can come from financial engineering, asset sales or a one-time windfall. In his 1987 letter Buffett described the businesses he wanted: an average return on equity above a high bar over ten years, and no single year below a lower one. Consistency signals a structural advantage, not a temporary spike.
AlphaStocks applies that test as written: ROE on average equity ≥ 15% in every year and ≥ 20% on average over 10 years (judged on at least 5). Return is measured on average equity for each fiscal year. A company like Apple (AAPL) that clears both bars every year passes; a cyclical firm with a strong average but one bad year fails, because Buffett's “no year worse than” is part of the test. Negative equity makes return on equity undefined, and undefined is a fail.
How Are Moat Signals Measured in the Numbers?
Buffett famously seeks businesses with “wide moats” — durable competitive advantages that protect profits from erosion. The advantages themselves (brand power, network effects, switching costs) are judgements no filing records, and AlphaStocks does not score them. What it measures is what a moat leaves in the numbers:
| Criterion | Passes when |
|---|---|
| Return on tangible capital ≥ 15% on average | after-tax operating profit ÷ tangible capital (equity + debt − cash − goodwill − intangibles) ≥ 15% on average |
| Moat signals in the numbers: durable returns and stable margins | return on tangible capital ≥ 15% in at least 80% of the years, and gross (else operating) margin with a coefficient of variation ≤ 0.15 across the window |
The tangible-capital test comes from Buffett's 1983 letter on economic goodwill: a great business earns a high return on the tangible assets it actually needs. The stability test follows the “quality” leg of the Buffett's Alpha paper (Frazzini, Kabiller & Pedersen, 2018); its cut-off is ours, not Buffett's.
Share Buyback Discipline
Buffett favours buybacks made below intrinsic value and objects to dilution from options. The model checks two things from the filings: diluted share count not higher than 5 years earlier, and — the 1983 letter's test of capital allocation — market value added ≥ $1 for each $1 of earnings retained over 5 years.
How AlphaStocks Uses the Buffett Quality Model
Each criterion is a pass or a fail; a criterion without the data it needs is left out of the count. The score is the share passed, and the status bands are: strong — ≥ 85% of evaluable criteria passed; attractive — ≥ 65%; neutral — ≥ 40%; reject — below 40%; insufficient data — fewer than 5 criteria evaluable.
In the AlphaStocks composite scoring system, the Buffett model carries 65% of the Quality axis in the general profile, and the Quality axis carries 40% of the composite. It is paired with the Piotroski F-Score (35% of Quality), which compares the latest fiscal year with the one before. If one of the two does not apply to a company, the Quality axis is the other alone.
Quality = Buffett × 0.65 + Piotroski F-Score × 0.35 (general profile)Sector Adaptations
The same criteria apply to every sector profile the model rates, with one adaptation and one exclusion, both from Buffett's own writing (see the Buffett methodology page):
| Profile | Treatment |
|---|---|
| General | All criteria, as written |
| Bank | Bank adaptation (1990 letter): owner earnings are reported earnings, leverage replaces the debt test, and the tangible-capital and margin criteria do not apply. |
| Insurer | Insurer adaptation (2007 and 2009 letters): judged on underwriting, returns and per-share book value; reported earnings stand in for owner earnings. |
| Asset manager | All criteria, as written |
| Holding company | All criteria, as written |
| Utility | All criteria, as written |
| REIT | All criteria, as written |
For example, Berkshire Hathaway (BRK.B) falls under the holding-company profile and is judged on the same criteria as any other company the model rates.
Limitations
The Buffett model favours mature, profitable businesses with ten years of history. High-growth companies that reinvest aggressively — reporting low or negative owner earnings despite strong revenue growth — will fail several criteria even if they are building significant economic value. A company with fewer years on file is judged on the years it has, down to a minimum; below that a criterion is unavailable.
Return on equity can be inflated by leverage. The debt test and the tangible-capital test, which counts debt as capital, catch much of that; negative equity is never read as low debt.
As with any single model, the Buffett assessment is most effective when combined with valuation, momentum, and timing signals in a multi-model composite.
Frequently Asked Questions
What is the owner earnings formula?
In his 1986 letter Warren Buffett defined owner earnings as reported earnings plus depreciation, depletion and amortization, less the capital spending needed to maintain the business. AlphaStocks computes net income + D&A − capital expenditures, and leaves stock-based compensation as the expense it is — Buffett called options compensation in his 1992 letter.
How does AlphaStocks use the Buffett quality model?
It is one of two models on the Quality axis (65% of Quality in the general profile; Quality is 40% of the composite). It checks criteria from Buffett's shareholder letters, each a pass or a fail: return on equity ≥ 15% every year and ≥ 20% on average; return on tangible capital ≥ 15% on average; moat signals in the numbers: durable returns and stable margins; owner earnings positive every year and growing; debt payable from three years of owner earnings, equity positive; each $1 retained added at least $1 of market value (5 years); diluted share count not higher than five years ago; price at or below 75% of intrinsic value. The score is the share passed out of the criteria the filings let us evaluate.
Why does AlphaStocks use different metrics for banks?
A bank's depreciation and capital spending are not its economics, and its debt is its raw material. Following Buffett's 1990 letter on Wells Fargo, banks keep the return-on-equity test and are judged on return on average assets ≥ 1.25% on average and total assets ≤ 20 × equity; the tangible-capital, margin and debt tests do not apply. Insurers get an adaptation from the 2007 and 2009 letters, labelled as one: total benefits, losses and expenses ÷ net premiums earned ≤ 100% summed over 10 years (judged on at least 5) — an upper bound on the combined ratio; not applicable when premiums are below 75% of total revenues; ROE on average equity ≥ 10% on average over 10 years and no year below 0% (judged on at least 5); book value per share, with dividends paid added back, compounded ≥ 10% a year over up to 10 years (at least 5); equity positive and net premiums earned ≤ 3 × equity.
What is a moat in Buffett investing?
A moat is a durable advantage that protects a business from competitors — brand, switching costs, network effects, cost advantages. None of these is recorded in a filing, so AlphaStocks does not score them. It scores "moat signals in the numbers", what a moat leaves behind: return on tangible capital ≥ 15% in at least 80% of the years, and gross (else operating) margin with a coefficient of variation ≤ 0.15 across the window.
Related Guides
This article is for educational purposes only. AlphaStocks provides algorithm-generated research tools, not personalized investment advice. The Buffett quality model is one component of a multi-factor scoring system. Past performance does not guarantee future results. Always conduct your own due diligence and consult a qualified financial adviser before making investment decisions. Data sourced from SEC EDGAR filings.