What it means
The idea of owner earnings was popularised by the investor Warren Buffett as an alternative to reported net income. Accounting profit includes non-cash charges such as depreciation (the spreading of an asset's cost over its life) and ignores the cash needed to replace worn-out equipment.
Owner earnings fix this by adding back depreciation and then deducting the spending required to maintain the business. The run rate part means taking a recent period, often the latest quarter or month, and multiplying it up to a full year.
For example, a quarter's figure is multiplied by four. It answers the question of what the business would earn over a year if the current pace simply continued.
Owner earnings are used by investors valuing a business, by buyers of small companies and by founders wanting to know how much cash their company really produces. A business with high reported profit but heavy maintenance spending can have weak owner earnings.
A business with modest profit and little reinvestment need can have strong ones. The hardest part is separating maintenance spending from growth spending.
Replacing an ageing delivery van is maintenance, while buying three extra vans for a new region is growth, and only the first belongs in the calculation. Estimating the split takes judgement, which is why two analysts can arrive at different numbers.
Run rates are only as reliable as the period behind them. A seasonal business that earns half its profit in one quarter will mislead if that quarter is simply multiplied by four, and a one-off gain or a delayed payment can distort a single month.
Using a trailing twelve months or an average of several quarters is safer.
In practice
Real-world examples.
Example
A buyer is considering a small printing business that reports $400,000 of annual profit. The presses must be overhauled for $150,000 every three years. The buyer deducts $50,000 a year for maintenance and values the business on lower owner earnings.
Example
A software company has almost no equipment to maintain and collects customer fees in advance. Its owner earnings run rate is higher than its reported profit because working capital falls as it grows. An investor values it at a higher multiple of owner earnings.
Example
A seasonal garden centre earns $500,000 in its spring quarter and loses $60,000 in each of the other three. Multiplying the spring quarter by four would suggest $2,000,000 a year, while the true total is $500,000 - 180,000 = $320,000. The analyst uses the trailing twelve months instead.
Formula
Calculation
Owner earnings = net income + depreciation and amortisation - maintenance capital spending - increase in working capital
Owner earnings run rate = owner earnings for the latest period x number of periods in a year
A company reports quarterly net income of $300,000, depreciation of $80,000, maintenance capital spending of $60,000, and an increase in working capital (stock and customer balances tied up in the business) of $20,000. Owner earnings for the quarter = 300,000 + 80,000 - 60,000 - 20,000 = $300,000. Run rate = 300,000 x 4 = $1,200,000 a year.
Reading the result: reported net income annualises to 300,000 x 4 = $1,200,000 as well in this case, but only because add-backs and deductions happen to cancel. If maintenance spending had been $140,000, owner earnings would be 300,000 + 80,000 - 140,000 - 20,000 = $220,000 for the quarter, or $880,000 a year, which is 26.7% lower than reported profit suggests.Case study
Seen in the real world.
Fernhill Bakeries is an illustrative, fictional company whose owner wanted to sell. The latest quarter showed net income of $150,000, so the owner quoted a run rate of $600,000 a year and asked for ten times that figure.
The buyer's accountant looked deeper. Ovens and vans needed about $200,000 a year of replacement spending, and a large new contract had increased stock and customer balances by $30,000 a quarter. Owner earnings for the quarter were 150,000 + 45,000 - 50,000 - 30,000 = $115,000, a run rate of $460,000.
At ten times, the price fell from $6,000,000 to $4,600,000 in this illustrative negotiation. The lesson is that the label on the profit figure matters less than the cash left after keeping the business running.
Watch out
Common mistakes.
- Adding back depreciation but forgetting to deduct the maintenance spending that depreciation is meant to represent.
- Multiplying a single strong or weak period by the number of periods in a year when the business is seasonal.
- Counting growth spending as maintenance, which understates the cash the owner could take out.
Questions
People also ask.
Is owner earnings the same as free cash flow?
They are similar, but owner earnings deduct only maintenance spending, while free cash flow usually deducts all capital spending, including growth.
What period should I use for the run rate?
Use the latest period only if earnings are steady, and otherwise use a trailing twelve months or an average across a full cycle.
Why do investors prefer it to net income?
Because it focuses on cash the owner could actually take out, after the cost of keeping the business at its current level.
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