Owner earnings is Warren Buffett's preferred measure of profit: reported earnings plus depreciation and amortisation, minus the capital spending required to maintain the business's competitive position. It aims to capture the cash an owner could genuinely withdraw each year without weakening the company.
What Buffett was objecting to
He set the idea out in the 1986 Berkshire letter, and the target was reported earnings. Net income is shaped by accounting choices about when revenue is recognised and how costs are spread, and it says nothing about the money a business must keep spending simply to stay where it is.
His observation was that accountants report a number that is precise and not the one an owner cares about, while owner earnings is approximately right about the question that matters. His phrasing was that it is better to be approximately right than precisely wrong.
The hard part is maintenance capex
Capital spending splits into two kinds that companies almost never separate. Maintenance capex keeps the existing business running: replacing worn machinery, refurbishing stores, refreshing servers. Growth capex builds something new, and it is an investment rather than a cost of this year's earnings.
Because the split is not disclosed, every owner earnings figure involves an estimate. Three usable approximations:
- Use depreciation as a proxy. Over a long period, maintenance capex and depreciation should roughly converge for a stable business. Crude, defensible, and the most common approach.
- Use capex in a flat year. Find a year when the company was not expanding and take what it spent then, adjusted for inflation.
- Scale capex to revenue. Take the historical ratio of capex to revenue during a period of no growth and apply it to current revenue.
Worked example
A company reports $300M of net income, $180M of depreciation and amortisation, and $260M of total capital expenditure. In a flat year three years ago it spent $150M.
Using depreciation as the proxy:
$300M + $180M − $180M = $300M
Using the flat-year figure:
$300M + $180M − $150M = $330M
Conventional free cash flow subtracts all capex:
operating cash flow of $480M − $260M = $220M
Free cash flow understates the business by treating $110M of expansion spending as though it were a running cost. That is the gap owner earnings exists to close.
How it differs from free cash flow
They are aiming at the same target and differ on one point. Free cash flow subtracts all capital expenditure, which is conservative and simple, and understates any company investing to grow. Owner earnings subtracts only maintenance capex, which is more accurate in principle and requires a judgement call that can be wrong in either direction.
Most investors use free cash flow for screening, because it is calculable from disclosed figures without an estimate, and reach for owner earnings when analysing a specific company where growth capex is large enough to distort the picture.
Where it matters most
In hyper growth and operating leverage, where heavy expansion spending makes free cash flow look far worse than the underlying business is. A company burning cash to build capacity ahead of demand can have strong owner earnings and negative free cash flow at the same time, and the distinction is the whole investment case.
The capex distinction matters most in one phase
Growth capex distorts free cash flow precisely when a company is expanding, and barely matters once it is mature. Phase Check places any US-listed company on the lifecycle so you know whether the adjustment is worth making.
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Frequently asked questions
Related
- Free cash flow, the simpler measure aiming at the same thing
- How to read a cash flow statement, where capex is disclosed
- Capital allocation, what management does with what is left
- Intrinsic value, the number owner earnings feeds