Owner Earnings

# Owner Earnings **Owner earnings** is Buffett's preferred metric for evaluating a business's true profitability. It represents the actual cash that accrues to owners over a given period, accounting for the capital investment required to maintain the business's competitive position. ## The Formula **Owner Earnings = Reported Earnings + Depreciation/Amortization/Depletion − Required Capital Expenditures** The key insight is that standard accounting treats capital expenditures as an expense for the period, but it treats depreciation as if it reflects the actual decline in asset value. This creates systematic distortions. ## Why GAAP Earnings Are Misleading GAAP earnings fail to capture several important realities: 1. **Inflation**: Depreciation of old assets does not reflect the cost of replacing them at today's prices 2. **Required capex**: Many businesses must constantly reinvest just to maintain their competitive position 3. **Non-cash charges**: Earnings are reduced by accounting entries that involve no cash outflow 4. **Capitalized expenses**: Some spending is capitalized rather than expensed, artificially inflating current earnings > "Reported earnings, all too often, are far more a measure of accounting assumptions than of business performance." ## The Three Categories of Businesses Buffett categorizes businesses by their capital requirements: **Category 1**: Businesses that require minimal reinvestment (e.g., See's Candies) - Owner earnings ≈ Reported earnings - Cash generative and ideal **Category 2**: Businesses that require significant reinvestment just to maintain position - Owner earnings < Reported earnings - The gap represents "maintenance capex" **Category 3**: Businesses that require massive reinvestment for growth - Requires careful analysis of whether growth creates value ## Practical Application When evaluating an investment, always ask: what capex is truly required to maintain the business's competitive position over the next decade? If the answer is a large fraction of reported earnings, the business's true owner earnings are much lower than they appear.