What Are Owner Earnings?
Owner earnings are Warren Buffett's estimate of the cash a business could hand to its owners each year without weakening its competitive position. The figure starts with reported profit, adds back non-cash charges such as depreciation, and subtracts only the spending needed to keep the business where it is. Buffett has argued it is the figure that actually matters when valuing a company.
Where the idea comes from
Buffett set out the concept in his 1986 letter to Berkshire Hathaway shareholders, in an appendix explaining why the accounting profit of a business Berkshire had bought didn't reflect its real economics. His point was that two sets of accounts can describe the same company in very different ways, and an owner should care about the one that tracks cash they could actually take out.
He was just as critical of a popular shortcut of the time, which added depreciation back to profit and stopped there. That ignores the fact that machines wear out and stores need refitting. A business that has to spend heavily just to stand still is worth less than its "cash flow" suggests. Owner earnings correct for this by subtracting the cost of standing still.
How owner earnings are calculated
In words: start with net income, add back depreciation, amortization and other charges that don't cost cash, then subtract the average yearly capital spending the business needs to maintain its long-term position and its sales volume. If the business also needs extra working capital, such as more inventory, just to hold its ground, subtract that too.
In symbols:
Owner earnings = Net income + Depreciation and amortization + Other non-cash charges − Maintenance capital expenditure
The key term is maintenance capital expenditure: spending to replace and keep up existing assets, as opposed to growth capital expenditure, which expands the business. Companies don't report this split, so you have to estimate it.
A worked example
The numbers below are invented for illustration.
A company reports:
Net income: $100 million
Depreciation and amortization: $40 million
Total capital expenditure: $70 million, of which you estimate $35 million is maintenance and $35 million is expansion
Owner earnings are $100 million + $40 million − $35 million = $105 million.
Standard free cash flow subtracts all $70 million of capital spending, so with operating cash flow of about $140 million it would come to roughly $70 million. The $35 million gap is the growth spending. Free cash flow treats that money as a cost. Owner earnings treat it as a choice the owners made to reinvest, cash they could in principle have taken out instead.
How to estimate maintenance capex
Because the whole calculation turns on this one estimate, it helps to know the common approaches.
Use depreciation as a stand-in. Depreciation is the accounting estimate of how fast assets wear out, so it is a rough proxy for what replacing them costs. It tends to understate the real cost when prices have been rising, because assets are recorded at what they cost years ago.
Strip out the growth. A method popularized by Columbia professor Bruce Greenwald looks at how much the company typically needs in fixed assets for each dollar of sales, multiplies that by the year's increase in sales, and treats the result as growth spending. Whatever capital spending is left over counts as maintenance.
Read the annual report. Some management teams describe how much they spend to sustain the business versus expand it. These figures aren't audited, but they are a starting point.
What good owner earnings look like
As with free cash flow, the absolute number depends on company size, so comparisons are more useful than a single target.
Against net income. In an asset-light business, owner earnings are often close to or above reported profit. In capital-heavy industries such as airlines, steel or car manufacturing, they can sit well below it, which tells you a large share of the profit has to be reinvested just to keep going.
Against the price. Dividing the company's market value by its owner earnings gives a multiple similar to a P/E ratio, but grounded in cash. A multiple of 15, for example, means an owner earnings yield of about 6.7%. Many investors compare that yield with what safer assets pay.
Over time. Owner earnings that grow steadily over many years point to a business that can expand without consuming all of its cash.
What counts as high or low varies widely by sector, so compare companies within the same industry.
What owner earnings don't tell you
The key input is a judgement call. Buffett himself acknowledged that maintenance spending has to be estimated. Two careful analysts can reach different figures, and an optimistic investor can always find a reason to label more of the spending as growth.
They don't tell you whether growth spending is any good. Owner earnings add back expansion spending as if it were optional. That is only fair if the expansion earns a decent return. Money poured into poor projects is still gone.
Stock-based pay can slip through. Like other cash-based measures, owner earnings can look flattering at companies that pay employees heavily in shares. Some investors subtract stock-based compensation to correct for it.
They don't suit banks and insurers. Their assets are mostly loans and investments rather than plants and equipment, so the idea of maintenance capital spending doesn't apply in the same way.
How to use owner earnings
Owner earnings work best as a way of thinking rather than a precise figure. When you look at any company, ask the owner's question: if I owned the whole business, how much cash could I take out each year and still leave it just as strong? Working through that question forces you to understand how much capital the business really consumes.
In practice, calculate owner earnings with a cautious maintenance estimate, compare the result with both net income and free cash flow, and look at the trend over several years. If all three tell a similar story, the accounts are probably a fair picture. If owner earnings are far above free cash flow, check that the company's growth spending has a record of paying off.
This owner's view runs through the way Buffett, Terry Smith and Chuck Akre write about businesses, and all three are among the 15 elite investors whose portfolios SIA tracks. Even so, a high owner earnings yield is not a buy signal by itself. It is one input into judging whether a price is fair.
Frequently asked questions
Are owner earnings the same as free cash flow?
No. Free cash flow subtracts all capital spending. Owner earnings subtract only the part needed to maintain the business, so for a growing company they are usually higher.
Why don't companies report owner earnings?
Accounting rules don't require companies to split maintenance spending from growth spending, and the split involves judgement. Investors have to estimate it themselves.
Can owner earnings be lower than net income?
Yes, when maintenance spending is larger than depreciation. That is common in heavy industries, and wherever replacing assets now costs more than it did when they were first bought.
The bottom line
Owner earnings ask what a business could pay its owners while staying as strong as it is today. The figure depends on an honest estimate of maintenance spending, which makes it more of a discipline than a formula. Used that way, it keeps your attention on the cash a business actually produces for the people who own it.
This article is for educational purposes only and is not investment advice.
