What is owner earnings?

What is owner earnings?

Owner earnings is the cash an owner can take out after keeping a business running. It starts with net income, adds back depreciation, and subtracts maintenance capital expenditure plus changes in working capital. It beats net income for valuing stocks.

You can't trust net income alone. It includes non-cash items like depreciation that don't hit your wallet. Owner earnings strips those out to show what you can actually pocket, giving a truer picture of the cash the business really produces.

How do you calculate owner earnings?

The formula is simple: owner earnings = net income + depreciation and amortization - maintenance capital expenditure - changes in working capital. Work through each term in order and the result is the cash an owner can actually extract.

Start with net income, the profit after all expenses. Add back depreciation because it's a paper charge, not real cash out. This step corrects the accountant's view with a cash perspective.

Subtract maintenance capital expenditure, the money needed just to keep the business running. Then subtract changes in working capital, like inventory and receivables. The result is the cash an owner can take out.

Why does owner earnings matter?

Owner earnings tells you what a business really generates in cash. It cuts through accounting noise. You can use it to see if a stock is cheap or expensive compared to its true earning power.

Buffett says owner earnings, not GAAP figures, are the relevant item for valuation. He called the equation "deceptively precise" because the maintenance capital expenditure part is a guess. But it's still the best measure of what an owner can take out.

Strong owner earnings mean a company can pay dividends, cut debt, or reinvest for growth. Weak or negative owner earnings? That's a red flag. The business might be burning cash just to stay alive, so watch the trend across years.

What are the limits of owner earnings?

There's no standard rule for calculating it. Different analysts use different guesses for maintenance capital expenditure, so the numbers vary. That makes comparisons tricky, so understand each assumption before judging the final result.

Working capital changes can swing wildly from year to year. A big inventory build or a slow-paying customer can distort the number. So look at owner earnings over several years, not just one, to smooth out the noise.

Owner earnings ignores stock-based compensation and other non-cash costs that still dilute shareholders. Use it alongside other metrics like free cash flow and return on capital to get a complete picture.

How does owner earnings differ from free cash flow?

Free cash flow is cash from operations minus total capital expenditures. Owner earnings starts from net income, adds back depreciation, and then subtracts only maintenance capital expenditure plus changes in working capital.

The real difference is the accounting starting point. Free cash flow counts all capital spending, while owner earnings starts from net income and adds back non-cash depreciation. That changes what you emphasize.

They also differ in which capex you deduct. Free cash flow subtracts every dollar of capital spending, while owner earnings subtracts only what the business must spend just to stand still. That is the discipline Buffett wants: know what a business needs just to stand still.

What is the owner earnings yield?

Owner earnings yield divides owner earnings by enterprise value, the price you would pay to own the whole business free and clear. It gives the going-in yield you would earn at today's price, before any growth.

Judge that yield against the risk-free rate and the earnings yield of other investments. Owner earnings yield runs higher than free cash flow yield, because you add back depreciation and deduct only maintenance capex, so know which one you are reading.

How do you estimate maintenance capital expenditure?

Maintenance capital expenditure is the hardest number to pin down. Bruce Greenwald offers a usable method. Start with property, plant, and equipment plus sales for the past five years, then turn them into a ratio.

Sum the property, plant, and equipment and sum the sales, then divide one by the other. That gives you the average PPE-to-sales ratio. Multiply it by the year-over-year change in sales to estimate growth capital expenditure.

Subtract growth capex from the current year's capital spending. Whatever is left is your estimate of maintenance capex. It is rough, but it is repeatable. You stop guessing blindly and start using a method you can defend.

Depreciation works as a fallback. A stable business must roughly spend what it wears out each year, so depreciation tracks maintenance capex closely. Use it when you have no better data, and check it against the ratio method when you can.