Warren Buffett: Owner Earnings vs. Free Cash Flow

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Abstract

In his 1986 Letter to Berkshire Hathaway shareholders, Warren Buffett laid out a definition and equation for “owner earnings” – a number that he said is “the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses.”

What is owner earnings? Before we get into a full explanation, let’s lay forth Buffett’s formula, as written in the aforementioned letter: “[Owner earnings] 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.”

It’s a mouthful; hence, the need for the discussion contained herein. Of course, investors as a group tend to have a need for immediate gratification and tend to seek out a single, simple, quick formula for investing. Because of those needs, free cash flow was born as the “armchair investor’s” owner earnings.

Though at times free cash flow and owner earnings are substantially the same, there are times that they differ greatly which can have a very significant impact on an investor’s estimation of intrinsic value. This report will outline the major differences between owner earnings and free cash flow. It assumes that the reader has, at the very least, a rudimentary understanding of financial terms and financial statements.

Warren Buffett: Owner Earnings vs. Free Cash Flow - The Start-Up

X-Widget Incorporated

For this discussion of free cash flow versus owner earnings, we’ll start by analyzing a fictional company:

X-Widget Incorporated. In doing so, the reader should end up with a strong grasp of how the income statement, balance sheet, and statement of cash flows are tied together to give a clear picture of the financial health and performance of a business.

X-Widget Inc. is a start-up company in the business of selling widgets. To start X-Widget Inc., the owner – Bob – decides to bear the costs of incorporating so that X-Widget starts with a clean slate. His attorney creates 10,000 shares of stock and gives Bob 1,000 shares, each with a par value of $1.00. Bob then invests $50,000. Thus, before any sales and before any other business is conducted, X-Widget’s income statement is zero – no income or expenses – and its day 1 (in this case, January 1) balance sheet is as follows:

Warren Buffett Owner Earnings vs. Free Cash Flow

Following this balance sheet is pretty straightforward. Bob put $50,000 into his business’ checking account; hence, $50,000 in Cash & Cash Equivalents. It wasn’t a loan to the company; rather, Bob invested in his company. His 1,000 shares of stock have a “par value” of $1.00 per share – or, $1,000. When he invested $50,000 into his company, $1,000 of that went to cover the $1,000 par value of stock and the rest went in as “Additional Paid-In Capital” – money Bob invested above and beyond the par value of the stock.

In this simple start-up example, the balance sheet tells just about the whole story to this point. In a more complex example, investors would definitely want to see a statement of cash flows. Let’s look at the cash flows for this period, and then get into business:

Warren Buffett Owner Earnings vs. Free Cash Flow

As you can see from this statement of cash flows, nothing was generated from the income statement (the “net income”) and you saw that there were no changes in inventories, accounts payable/receivable, etc. That is, there was absolutely no cash flow from “operating activities” because the business did not start operating. No property or equipment was purchased; so, there was no cash flow from “investing activities”. The balance sheet showed $50,000 of cash – $50,000 more than it had before Bob invested. His investment is reflected in the cash flows from “financing activities”.

The First Sale (and Quarter)

Now that X-Widget Inc. has been funded, it is ready to hit the ground running. Bob buys a widget stamp – the $20,000 machine he desperately needs to start making widgets. He spends $1,000 on business cards, brochures, and other marketing materials. In addition, his new business phone is going to cost him $50 a month.

Ready to make his first millions, Bob hires a commission-only sales rep to pound the streets and drum up business. Bob estimates that the cost of manufacturing a widget is $5,000. If he sells them for $10,000 and gives the sales rep a 25% commission ($2,500), Bob will turn an operating profit of 25%, or $2,500 for each widget sold ($10,000 minus $2,500 in commissions minus $5,000 cost to produce = $2,500).

By the way: To keep things simple, Bob will be operating out of his garage and won’t be paying any rent or taking any home write-offs.

On February 15, 2006, the sales rep brings in an order for five widgets – a total order of $50,000. Bob records the sale in his accounting software and gets to making the product. It takes six weeks to make the widgets, including delivery, and the customer has thirty days to pay upon acceptance. Assuming the customer holds payment until the last possible moment, Bob should collect a check for $50,000 around the end of April.

The first quarter comes to a close on March 31, 2006, and Bob prepares his financial statements:

Warren Buffett Owner Earnings vs. Free Cash Flow

Not many businesses turn a profit their very first quarter. By traditional measures (particularly those on Wall Street), Bob’s business is doing extremely well. We now turn to check out his balance sheet:

Warren Buffett Owner Earnings vs. Free Cash Flow

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