What Are Owner Earnings?
How much profit does a company make? This may seem like a simple question but in reality is chock-full of nuance. There's the net income which shows up on a company's income statement - this is the number that most people focus on. The big problem with net income is that it is by definition an accounting number. Capital expenditures made by a company are depreciated over many years, so a company could be hemorrhaging money with net income largely unaffected. Also, non-cash charges, such as write-offs, are deducted from net income. These don't affect the amount of cash a company generates but reduce the "earnings" none the less.
A better option is looking at the free cash flow. Free cash flow is a measure of the actual cash generated by a company. Free cash flow is convenient to use because it shows up directly on the cash flow statement. But there is actually a better option: Owner Earnings. Warren Buffet, famed value investor and CEO of Berkshire Hathaway, defined owner earnings in his 1985 letter to shareholders.
These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges...less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume....Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes...All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) - but do not subtract (c). Warren Buffet
At first glance this definition of owner earnings appears to be nearly identical to that of free cash flow. However, there are important differences. Owner earnings is the amount of cash which can be pulled out of a company each year if capital expenditures are limited to only maintenance capex - only capital expenditures needed to maintain the current business. The amount of capital expenditure listed on the cash flow statement is the total, comprised of both maintenance capital expenditures and growth capital expenditures. Furthermore, this maintenance capex should be averaged over a few years to smooth out the result.
Another difference between free cash flow and owner earnings is that free cash flow includes changes in working capital. In general, working capital fluctuates from year to year, and these fluctuations clearly should not be counted. They would have the effect of unduly inflating or depressing the picture of profitability. Only necessary changes in working capital needed to maintain the business should included in the calculation of owner earnings, so they can usually be ignored. The formula for owner earnings is as follows:
Owner Earnings =
+ Depreciation, amortization, etc.
+ Non-cash charges (not related to working capital)
+ Interest payments adjusted for taxes
- Average maintenance capital expenditures
- Permanent changes in working capital
It's important to remember what owner earnings represent: it is the average amount of cash which can be pulled out of a business after all expenditures necessary to maintain the business and the current unit volume. I've added interest payments since I want to calculate the profit I would be able to pull out each year assuming I bought the company outright and paid off all outstanding debt.
Owner earnings allows you to value a company based on its current profitability. However, maintenance capex is not a generally available number and is often difficult to determine. Using the total capital expenditure will most likely underestimate the profitability of the company.
If you use owner earnings in a discounted cash flow calculation, you must be careful. If only maintenance capex is subtracted then projecting growth faster than inflation doesn't make any sense since the growth isn't being paid for. If you project real growth after inflation, you must use the total average capital expenditures.