Warren Buffett’s Owner Earnings

In 1997, during Berkshire Hathaway’s Annual Meeting, Warren Buffett stated that GEICO’s gain in intrinsic value is substantially greater than represented by the company’s reported earnings. To thus get a more accurate representation of a company’s intrinsic value, Warren Buffett introduced “owner earnings” in his 1986 letter to shareholders.

“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, 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 may same way too complicated, but we can simply present this formula as:

    Owner Earnings= Reported earnings + Depreciation/ Amortization +/- noncash charges – average annual maintenance capex +/- changes in working capital

Owner earnings are the amount of cash that can go straight into the owner’s pockets without hurting the businesses operations. Many will point out that this formula is not as precise as GAAP earnings because we will have to estimate maintenance capex, but as John Keynes put it: “I would rather be vaguely right, than precisely wrong.”

So how do we estimate Maintenance Capex? Bruce Greenwald, a professor at Columbia Business School, came up with a simple method to estimate maintenance capex. The method goes as follows:

1.  Calculate ratio of PPE to sales for 5 years and get the average.

2.  We then multiply the ratio by the growth/ decrease in sales dollar the company has achieved in the current year. This gives us the growth capex.

3.  We then subtract the growth capex from total capex giving us maintenance capex.

Where can we find the other inputs?

1. Reported earnings – Income Statement

2. Depreciation/ Amortization – Cash Flow Statement

3. Non- Cash Charges – Cash Flow Statement

4. Changes in working capital - Balance sheet.

Let’s use Intuit (NASDAQ: INTU) as an example. Intuit “helps consumers, small businesses, and the self-employed prosper by delivering financial management and compliance products and services. We also provide specialized tax products to accounting professionals, who are key partners that help us serve small business customers.” We will calculate Intuit’s owner earnings for 2022, now let’s get our inputs.

(in millions)

Reported Earnings= $2 066

Depreciation/ Amortization=$746

Non-Cash Charges=$203 (I didn’t include SBC, as I view it as a legitimate expense that dilutes shareholders)

Maintenance CapEx

Maintenance CapEx= CapEx- (Average PPE as a % of sales x Sales growth/decrease)

                                     =157-(4.89% x 3093)

                                     = $5.75

Changes in Working Capital 

   =(Total current assets- total current liabilities)₂₀₂₂ - (Total current assets- total current liabilities)₂₀₂₁

      = (5047-3630) – (5157-2655)

      = -$1805

We now have all the required inputs and can hence calculate Intuit’s 2022 owner earnings.

                                 Owner Earnings=$2066 + $746 +$203 - $5,75- $1805

                                                             =$ 1204.25(in millions)

In an “earnings” obsessed Wall Street, Owner earnings are not widely used tool. For investors who aim to compound their capital over long periods of time by investing in quality companies, incorporating owner earnings in their valuation method can result in better informed investing decisions and hence above average results.