Buffett's Favourite Metric: Owners Earnings
AuthorDavid Fourie Stephens
To value a company you essentially need 3 things: an input metric, growth rate and discount rate.
In this article, I'm going to talk about Buffett's preferred input metric "owners earnings".
This metric is also used by Phil Town to value a company using his "10 Cap" method. See video,
Buffett first mentioned the concept of owners earnings in his 1986 shareholder letter to Berkshire investors.
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 Ns 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.)
This is quite a loaded quote, a more concise breakdown can be seen below:
Owner Earnings =
(a) Reported Earnings
+ (b) depreciation, amortization
+/- (b) other non cash charges
(c) average annual maintenance capex
+/- changes in working capital
The easiest way to think about owners earnings, as compared to free cash flow, is how the capital expenditure component is treated.
Free Cash Flow (FCF) = Cash From Operations - Capital Expenditure
Owner Earnings = Cash From Operations - Maintenance Capital Expenditure
Owner earnings breaks the capital expenditure component down into two components i.e., growth capital expenditure and maintenance capital expenditure. Growth capital expenditure is expenditure employed to potentially grow a company e.g. opening a new restaurant while maintenance capital expenditure is expenditure employed to maintain a company's competitive position e.g. replacing kitchen equipment in restaurant. So, to calculate owners earnings, you only consider the maintenance component of capital expenditure.
The 2 videos below gives a good summary of owners earnings:
As the above videos highlight, the problem with maintenance capital expenditure is that companies do not normally share this figure. Some companies give a breakdown of their capital expenditure which can be useful to estimate maintenance capital expenditure.
One way to approximate maintenance capital expenditure is to use a ratio of capital expenditure to sales over multiple past years e.g. 5 years, and follow these steps:
1. Sum of property, plant, and equipment (PPE) from the balance sheet for the past 5 years
2. Sum sales from the income statement for the past 5 years
3. Dividing the sum of PPE by the sum of sales to find the average ratio of PPE-to-sales
4. Multiply the PPE-to-sales ratio by the increase or decrease in sales from the prior year to the current year to find growth capital expenditure
5. Subtract calculated growth capital expenditure from the current year's capital expenditure to find maintenance capital expenditure.
The example below follows these steps:
Now finally why would you want to use owners earnings instead of the free cash flow metric to value a business if it is more difficult to estimate? The answer is in the name, the output from owners earnings is closer to what a business owner would receive because the growth component of capital expenditure is a somewhat discretionary decision. Here is an example, suppose you owned McDonald's, do you really need to open another franchise to survive as a company? No, but you do need to ensure that the restaurants are maintained to survive as a company.
Free Cash Flow = Cash Received From operating McDonald's - Expenditure on New Restaurants - Expenditure on Maintaining Restaurant
Owners Earnings* = Cash Received From operating McDonald's - Expenditure on Maintaining Restaurant
* You as business owner can decide whether to spend money on a new restaurant.