What is Owner Earnings?

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Jae Jun

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Owner Earnings Explained

 

Owner Earnings

Owner Earnings Explained | Flickr: kenteegardin

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 amount an owner receives from his business.

How is Owner Earnings Calculated?

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

Now that is clearly 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

But when Warren Buffett wrote this in 1986, accounting was different than today with less information available. Time to break this down a little further to make sense of it.

Some Differences between Owner Earnings in 1986 and Today

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 didn’t really involve any cash.

Maintenance Capital Expenditure: This is the main difference between 1986 and today. Without a cash flow statement 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. Capital expenditures is located in the cash flow statement. The only difficult part is to figure out how much of the total capex goes to 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 since it is very difficult to accurately calculate it.

Working Capital: Buffett also mentions “additional working capital” in the paragraph. He says that additional working capital “should be included in (c)”. 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.

(Refer to another explanation towards the end of the previous article on changes in working capital)

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

MSFT Owner Earnings Example

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

  • Net income = $23,344
  • D&A = $2,859
  • Other non cash charges = $4,163
  • Capex = $2,325
  • Changes in working capital = ($1,024)

MSFT TTM Owner Earnings =

$23,344

+ $2,859

+ $4,163

- $2,325

+ $1,024

= $29,065

Try it with the numbers from Morningstar and see what you get.

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.

It may take some practice at first and depending on the type of company you look at, owner earnings may be more difficult to calculate, but with practice, you will have taken one step closer to being like Warren Buffett.

About Jae Jun


Jae Jun is the founder of Old School Value. He is on a mission to provide practical and actionable value investing tools, tutorials and educational material to help empower the individual investor. Keep in touch with Jae via any of the methods linked below.

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  • alex

    It was my understanding that an increase in working capital is like capital maintenace as they are additional investments in the business to maintan or grow the business, and therefore should be included as part of the capital expenditure. These expenses are not part of the owner’s earnings because they are plowed back into the business.

    Therefore an increase in capital expenditure should be subtracted from the net income. In your calculation you turned that into a positive figure.

    So using your numbers, I have an owners earnings of 27,017.

  • http://www.oldschoolvalue.com Jae Jun

    Increase in working capital varies year to year so it would be better to average it out with previous years otherwise you will end up overstating or understating it quite often.
    That is why I eliminate working capital, unless there is a huge difference between the previous year of course.

  • somrh

    Jae,

    If D&A is higher than current capex, what reason do we have for believing that maintenance capex is lower than D&A?

    What if it’s the case that MSFT is withholding, for as long a possible, maintenance capex and therefore current capex understates maintenance capex.

    Or alternatively if MSFT is a sort of company that needs to make large purchases at infrequent times (say once every 10-20 years) then those purchases won’t show up on current CAPEX but will show up in D&A.

    Wouldn’t it be more conservative to use the higher D&A instead of the lower current CAPEX to estimate maintenance CAPEX? Or do we have reason to believe that D&A overstates maintenance CAPEX in this particular case?

  • Felix

    As per Alex,

    It is my same understanding that if you are to include changes in working capital to calculate owner’s earning, then if there is:

    1) Increase in Change to Working Capital (Incr), so negative on the cash flow statement, you would subtract it from the Net Income like it was an additional maintenance capital expenditure

    2) Decrease in Change to Working Capital Desc, so positive on the cash flow statement, you would add it to the Net Income like it was a relief of payables.

    I have the owner’s earnings of 27,017 as well.

    On a side note, there is a discrepancy with the owner’s earnings shown in your Stock Valuation PDF Sample of your Stock Valuator product (http://www.oldschoolvalue.com/blog/wp-content/uploads/OSV_Stock_Valuation_PDF_Sample.pdf)

    There, the example of MSFT for 2010, 2011, you do not include changes in working capital as per Mr. Buffett’s advice “Otherwise, the rest of working capital should be excluded from owner earnings.”

    Any comment on that?

    Felix

  • Alex

    Yes that was my point. The math on Jae Jun’s calculation is reversed. Subtracting a negative number yields an addition.

  • http://www.oldschoolvalue.com Jae Jun

    ah I see what you were referring to.
    The capex number I changed to a +ve value to make the calculation make sense on paper instead of using an excel version.

    It’s the working capital change value I got mixed up with. Should be a plus as you said.

  • lasse

    I can’t see how you calculate the values for ‘other current assets’ , ‘other current liabilities’ and ‘other working capital’ when comparing to the cash flow statement. Can you be please explain ?

  • http://www.valuefolio.com Daniel Sparks

    I just want to make sure I understand this. I noticed the TTM Owner earnings for MSFT you came up with was: 27,017. But on your screen shot it says: 29,065. When I do the math from the numbers in the screenshot I get 27,017. Is there a reason for this difference?

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  • http://www.oldschoolvalue.com Jae Jun

    @ lasse,

    Those values come directly from the data source.

    Other current assets: The increase or decrease between periods of the other current assets. Other current assets includes all other current assets that are not assigned to accounts receivable and inventories.

    Other current liabilities: The increase or decrease between periods of other current assets. Other current liabilities includes all other current liabilities that do not fit into short-term debt.

    Other working capital: The increase or decrease between periods of the working capital. It is the amount left to the company to finance operations and expansion after currnet liabilities have been covered.

  • http://www.oldschoolvalue.com Jae Jun

    @ Daniel,

    You are correct. The reader above mentioned that I had my symbols reversed. The correct number is 27,017.

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  • Chee Siang LIM

    Why is it that the owner earnings include “Changes in net working capital” when you have argued previously that such changes should not be included in owner earnings?

  • http://www.oldschoolvalue.com/ Old School Value

    Remember that to eliminate the effects of changes in working capital, it has to be either added or subtracted. E.g. if changes in working capital is $100, you need to subtract it out. So in the formula, it is included, but the concept is removing it.

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