Owner earnings

In the appendix to the 1986 Berkshire Hathaway letter, Buffett defined what he actually wants to know about a business. Owner earnings are reported earnings, plus depreciation, depletion, amortization and certain other non-cash charges, less the average annual capitalized expenditure for plant and equipment (and the like) that the business requires to fully maintain its long-term competitive position and unit volume. Any required increment in working capital is included in that subtraction. He added, pointedly, that because maintenance capex has to be estimated, owner earnings can't be computed to the decimal, and that he'd rather be vaguely right than precisely wrong. The jab was aimed at "precise" GAAP numbers and at cash-flow figures that conveniently ignore reinvestment.

In the vocabulary used here:

Owner earnings = net income
               + D&A and other non-cash charges
               − maintenance capex                  (estimated — §4.7)
               − ΔWC required to maintain position   (normalized, not this year's swing)

How do owner earnings reconcile to free cash flow?

Reconcile it to FCF and the two instruments snap into focus:

FCF            = CFO − total capex
Owner earnings ≈ CFO (with WC normalized) − maintenance capex only

Owner earnings − FCF ≈ growth capex ± WC normalization

When OE > FCF, you're looking at a grower. FCF is depressed by growth capex, and that capex is an investment. Avenue Supermarts in its build years had thin or negative FCF and solidly positive owner earnings. Once the store network is built it gushes cash, and the building was a choice. Value a company like that on FCF alone and you'll systematically undervalue it. Value it while ignoring whether the growth capex pays its way and you'll systematically overvalue it. You need both guard rails.

When OE < FCF, you're looking at a melting ice cube. A declining business spending below maintenance prints beautiful FCF, and print media is the classic case. Take an illustrative one: NI ₹100 crore, D&A ₹80 crore, capex ₹20 crore, so CFO ≈ ₹180 crore, FCF ≈ ₹160 crore, and FCF/PAT a spectacular 160%. But holding volume actually needs ~₹70 crore of capex, so owner earnings ≈ 100 + 80 − 70 = ₹110 crore, and even that decays every year. The extra ₹50 crore of "free" cash is the business being liquidated in instalments. FCF flatters harvesters just as much as it punishes builders, and owner earnings corrects the lens in both directions.

Should you use owner earnings or free cash flow?

Which number for what? Use the comparable restated FCF for screening and conversion ratios. Use it for the cash walk too, because you can compute it and audit it. Use owner earnings for valuation thinking, because it's the number a rational private owner would capitalize. The FCFF forecasting you'll do in valuation is, in spirit, owner earnings with the estimates made explicit and the growth capex modeled instead of excluded.