Owner Earnings
Warren Buffett · 1986
"The number that matters for valuation is not reported earnings or 'cash flow' but owner earnings: reported earnings, plus depreciation and other non-cash charges, minus the capital spending needed just to hold the business's competitive position. Skip the last subtraction and you are pricing the business as if it were the Pyramids."
Berkshire bought Scott Fetzer in January 1986. Under purchase accounting the same company, run by the same people, selling the same products, reported $28.6 million of earnings instead of $40.2 million — the difference being $11.6 million of new non-cash charges for stepped-up inventory, depreciation and goodwill that were not even tax-deductible. Buffett's question in the appendix to that year's letter was simple: did Berkshire buy a business earning $40 million or one earning $29 million? Both figures were GAAP-correct, and neither was the answer.
His answer is owner earnings: (a) reported earnings, plus (b) depreciation, depletion, amortization and other non-cash charges, minus (c) the average annual capital expenditure the business needs to fully maintain its long-term competitive position and unit volume, including any working capital it must add to do so. Item (c) is a guess, and sometimes a hard one, which is why the formula gives no deceptively precise GAAP figure — Buffett quotes Keynes: better to be vaguely right than precisely wrong. Applied to the two versions of Scott Fetzer, owner earnings come out identical, as common sense says they should, because (a) plus (b) is the same in both columns and (c) does not care about accounting. The sharper edge of the appendix is aimed at Wall Street's 'cash flow', which adds (b) to (a) and never subtracts (c). That implies the business is the commercial counterpart of the Pyramids — forever state of the art, never needing replacement. For a bridge or a very long-lived gas field the shorthand may serve; for manufacturers, retailers, extractive companies and utilities, (c) is always significant and 'cash flow' is meaningless. Even See's Candies, a business that needs little capital, spent $500,000 to $1 million a year more than its depreciation simply to hold its ground. Buffett's cynicism about why the number is popular is explicit: when GAAP earnings cannot justify a junk bond's debt or a foolish stock price, salesmen switch to (a) plus (b). Ignore your teeth and they will go away, he notes; the same is not true of (c).
According to Buffett, what is wrong with the 'cash flow' figure commonly presented in Wall Street reports?
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The explanation above is written with AI assistance. These are the originals — go to them to check it.
- Chairman's Letter — 1986: Owner earnings & the 'cash flow' fallacyWarren Buffett / Berkshire Hathaway
Great, Good, and Gruesome Businesses
"A truly exceptional business must possess an enduring competitive advantage — an economic moat — that protects its high returns on invested capital from the relentless assault of free-market capitalism."