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What You Will Learn

What is owner earnings really is

How to calculate owner earnings to find how much the owner receives from his business

Examples of how to calculate owner earnings

The Difference Between Earnings and Owner Earnings

In Wall Street terms, earnings is net income or EPS from the income statement. This is what most people grab and hold onto when the term earnings comes up.

But in value investing, earnings also refers to a FCF variation in the cash flow statement. i.e. owner earnings.

The whole concept of owner earnings is to figure out how much cash falls into the business owner’s pockets.

Net income and EPS is all very nice under accounting principles, but the actual dollar value that the business owner receives at the end of the day/month/year is much different.

This is why Buffett calls it owner earnings.

He likes to look at the real dollar amount an owner can withdraw from the business without affecting operations.

Owner Earnings Calculation

As I brought up when discussing changes in working capital, Buffett first publicly announced the phrase owner earnings, in his 1986 Berkshire letter.

Here it is again.

“If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) 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. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)” – 1986 Berkshire letter

This is a confusing block of text.

Breaking it down into digestible pieces, you have

Owner Earnings =

(a) Reported Earnings

+ (b) depreciation, amortization

+/- (b) other non cash charges

– (c) average annual maintenance capex

+/- changes in working capital

But when Warren Buffett wrote this in 1986, accounting rules were different with less information available.

Time to break this down a little further to make sense of it.

Owner Earnings in 1986 vs. Present Day

Reported Earnings: Easy. You can still find net income from the income statement.

Depreciation, depletion and Amortization: This number is provided in the cash flow statement.

Other non cash charges: Also found in the cash flow statement and refers to any charges which did not involve cash. Things like employee stock compensation.

Maintenance Capital Expenditure: This is the main difference between 1986 and today. Without a statement of cash flows it is difficult to calculate what the capital expenditure is, let alone maintenance capex.

That is why Buffett took the average approach.

But how did he calculate maintenance capital expenditure?

I believe Buffett looked at the depreciation and amortization figure and averaged it out over many years. The concept is that the D&A is a starting base figure for maintenance capex. (I wrote about this in my maintenance capex using depreciation article)

In other words, say I bought a computer for my business at a cost of $2,000 because I have to write articles and create stock value calculators to maintain my business.

If the computer has a lifespan of 5 years, that means I am going to depreciate $2,000 over 5 years. Using the straight line depreciation method, my depreciation is $400 for the next 5 years.

Basically, it is going to cost me $400 each year to maintain my business with the work I do on my computer.

But you and I have it good. The total capital expenditures is already located in the cash flow statement.

The only difficult part is to figure out how much of the total capex goes towards maintaining the business and growth.

You can use Bruce Greenwald’s method of calculating maintenance capex, but it does have its limitations. Or do what I do and just use the full capex figure because of the difficulties in accurately calculating it.

Better to be conservative, than underestimate maintenance capex and overpay for a stock.

Working Capital: Buffett also mentions “additional working capital” which is another way of saying “changes in working capital”. Remember that Buffett wrote that letter in 1986 before the official term “changes in working capital” existed.

Buffett is simply talking about the importance of cash flows due to working capital.

The increment he is referring to is the increase in the current operating assets in the “change in working capital” calculation. Whether the asset or liabilities side has the increment is going to determine whether you include or exclude the change in working capital.

If the change in working capital is negative , that means working capital increased as the company needs more capital to grow. This reduces cash flow and so it should reduce the owner earnings. (excluded in this case)

, that means as the company needs more capital to grow. (excluded in this case) If changes in working capital is positive, that means working capital decreased as the company has more cash for the company to grow and play with. This increases cash flow and so it should added to owner earnings. (included in this case)

Just goes to show how ahead of the curve Buffett really was. Be sure to read the complete guide on changes in working capital to understand it completely.

This means that on any given year where additional working capital is required to maintain the business, it should be included in capex. Otherwise, the rest of working capital should be excluded from owner earnings.

Owner Earnings Formula for Today

Based on the discussion above, the owner earnings calculation now looks like this.

Owner Earnings = (a) Net Income + (b) depreciation, amortization +/- (b) other non cash charges – (c) annual maintenance capex (or the full capex)

+/- changes in working capital

Microsoft Owner Earnings Formula

Let’s quickly go through an example for MSFT’s Trailing Twelve Months. All values taken from the stock value calculator.

Using the TTM figures in millions:

Net income = $12,273

D&A = $5,990

Other non cash charges = $2,598

Capex = $6,018

Changes in working capital = ($1,471)

Because changes in working capital is negative, it should reduce FCF because it means working capital has increased and decreases cash flow (read the change in working capital article to fully understand this concept)

Therefore, Microsoft’s TTM owner earnings comes out to be:

12,273+5,990+2,598-6,018 – 1,471 = 13,372

The goal to calculating owner earnings properly is to understand the core concepts.

Mainly:

calculate the change in working capital determine whether the cash flow will increase or decrease based on the needs of the business add or subtract the amount to cash flows to get owner earnings

Amazon Owner Earnings Formula

Using the same method, here are the calculations.

Using the TTM figures in millions:

Net income = $328

D&A = $5,909

Other non cash charges = $2,001

Capex = $4,424

Changes in working capital = $6,422

Owner Earnings = 328 + 5909 + 2001 – 4424 + 6422 = 10,236

Unlike Microsoft, Amazon changes in working capital is positive. It is added to the owner earnings as the company needs less capital to grow and so it will increase cash flow.

If you now divide the owner earnings by shares outstanding, you get owner earnings per share which is essentially the value investors version of EPS.

Congratulations, you now understand the inner workings of owner earnings.