Buffet was seeking to compute a more realistic cash based earnings figure from a company’s income statement. It is important to note that a company’s income statement doesn’t provide actual cash movements into and out of a business because accountants use, amongst other things, the concept of accruals; matching invoiced income and expenses within the accounting period as opposed to when cash actually changes hands.
You can read Buffet’s original “owner earnings” approach in Berkshire Hathaway’s 1986 chairman’s letter where he begins his insight by delving into ‘purchase-price accounting adjustments and the “cash flow” fallacy’. It’s certainly a worthy read for any aspiring investor.
Investors, over time, have taken differing routes to modernise owner’s earnings for today’s investment world. My take is that owner’s earnings is a method to approximate the true cash earnings potential of a company that seeks to maintain constant production output. This fixed volume interpretation is important because it suggests we should only deduct a company’s maintenance capital expenditure (capex) to arrive at an adjusted free cash flow figure; not growth capex. By only deducting maintenance capex, we must acknowledge we aren’t fully reflecting the costs a company faces to run and improve its core operating business. Yet excluding growth capex provides us with a more valuable comparison tool for normalised free cash flow generation of a company versus its peers, because, we are stripping out the volatile timing of growth capex spend between company A and company B.
