Thursday, December 11, 2008

Owner Earnings: What is it and Why it Counts

Remember the very first thing that we were told in any good book on common stock investing: When you buy the common stock of a company you become a part owner in the underlying business. As owners evaluating the earnings power of a company, our focus should be on the earnings that are available to the owners every year. This is simply the amount of cash that can be taken out of the business every year and distributed to the owners without affecting the current operations/profitability of the business. How do you get this amount?

Start with the reported GAAP earnings:
a. Add back depreciation, amortization and certain non-cash charges.
b. Subtract maintenance capital expenditures.
c. Undo the effects of one-time items.

Note on (a): The question of which non-cash charges to add back to earnings is subjective. The one non-cash charge that I feel strongly about and would not consider adding back to GAAP earnings is stock compensation expense.

Also, note that we ignore changes in working capital in the calculation of owner earnings. Growth in operational cash flow powered by a significant change in working capital is not likely to be sustainable(there are limits to how quickly you can collect payments from people that owe you and how much you can put off paying people that you owe money to). So, while positive changes in working capital management is welcome, the nature of these improvements is such that they are not recurrent enough to warrant their inclusion in the calculation of owner earnings.

Update: On reflection, while it may be prudent to ignore positive changes in working capital, cases where sales growth necessitates increased working capital investment require different treatment. In such cases, it'd be worthwhile to charge for the increase in working capital(higher levels of inventories, for e.g.) to arrive at an owner earnings estimate.

There are two types of capital expenditures:
a. Maintenance capex which is needed in order to maintain current profitability. e.g. replacement of old equipment/worn-out buildings. Estimation of this amount is the tricky part.
b. Growth capex which is spent for growth. e.g. building a new factory to enable additional sales.

In general, companies do not provide a breakdown of the two types of capex. They are invariably lumped together under the Statement of cash flows under the Investing Activities section as Additions of Property and Equipment. It is necessary though to guesstimate the maintenance capital expenditures, for otherwise it is not possible to come up with an estimate of owner earnings. A reasonable question to ask at this point is: Why do we need maintenance capex estimates when depreciation is intended to fulfill that very purpose? Simply because depreciation is based on historical costs which may/may not be relevant today.
If depreciation is much smaller than maintenance capex, GAAP earnings vastly overstate the earnings power of the company in question.

Warren Buffett first introduced the concept of Owner Earnings in his 1986 letter to shareholders. I'd highly encourage readers to read it:
Look for the beautifully written section titled 'Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy'.

Often wrong but seldom in doubt,


  1. Good explanation of the confusing accounting jargon. I like the bottomline explanation. Can you pick up a company's quarterly report and work through the numbers -- that would be enormously valuable.

    A doubting fan!

  2. Heh. Better a "doubting fan" than no fan at all, that's for sure. I will provide a working example, most likely for Steak 'N Shake.


  3. Ragu,

    Buffet's note was an interesting read, thanks for the link.

    I was reading a post on where it was mentioned that FCF is more applicable to toy industry than earnings.

    When is it appropriate to use FCF and when the earnings to evaluate a business ?


  4. Qleap,

    You're welcome. As for your question about using FCF vs earnings, I'll say this: You are always better off figuring out what the true "economic earnings" of a business is and that's what owner earnings really represents.

    In businesses where there is a large initial capital outlay followed by minimal incremental capital expenditures, GAAP earnings will substantially understate the true earnings power of the business(perhaps the toy industry falls into this category?).