Warren Buffett's favorite way to measure profit isn't Net Income or Free Cash Flow.
It's Owner's Earnings.
What is it? How to does it work?
In this thread, I'll walk you through the calculation:
It's Owner's Earnings.
What is it? How to does it work?
In this thread, I'll walk you through the calculation:
Imagine that you're opening a coffee shop.
You spend $100k on furniture & fixtures that will last 10 years.
You spend $60k on coffee equipment that will last 3 years.
Here are your total annual operating costs:
You spend $100k on furniture & fixtures that will last 10 years.
You spend $60k on coffee equipment that will last 3 years.
Here are your total annual operating costs:
You make $1 million in revenue, so here's your income statement:
Revenue: $1,000k
Expenses: $450k
Pre-tax income: $550k
Taxes: $110k
Net Income: $440K
If you started with $105K in cash, how much do you have now?
Revenue: $1,000k
Expenses: $450k
Pre-tax income: $550k
Taxes: $110k
Net Income: $440K
If you started with $105K in cash, how much do you have now?
You might think $105k (start) + $440k (profit) = $545k
But that's wrong.
Why? You forgot about the $30k in "non-cash" charges (depreciation).
But that's wrong.
Why? You forgot about the $30k in "non-cash" charges (depreciation).
Your net income was $440K, but your operating cash flow was $470K.
So, can you safely withdraw that $470k from the business each year?
NO!
Here's why:
So, can you safely withdraw that $470k from the business each year?
NO!
Here's why:
In 2 years, you'll have to replace the coffee equipment (which cost $60k)
In 9 years, you'll have to replace the furniture (which cost $100k)
However, due to inflation, that equipment will be MORE EXPENSIVE in 2 and 9 years than it was initially!
In 9 years, you'll have to replace the furniture (which cost $100k)
However, due to inflation, that equipment will be MORE EXPENSIVE in 2 and 9 years than it was initially!
Lets say those costs will be $70k & $200k.
So, we have to set aside an extra $23k/year ($70k/3) and $20k/year ($200k/10) to pay for those future equipment costs!
That means the amount we can actually take out of the business is $422k ($470k - $23k - $20k)
So, we have to set aside an extra $23k/year ($70k/3) and $20k/year ($200k/10) to pay for those future equipment costs!
That means the amount we can actually take out of the business is $422k ($470k - $23k - $20k)
That $422k is "owner's earnings"
It's how much cash the business owner can safely withdraw each year *without* hurting the earning power of the business.
Buffett uses this number for all valuation calculations
It's how much cash the business owner can safely withdraw each year *without* hurting the earning power of the business.
Buffett uses this number for all valuation calculations
Remember - there are multiple ways to measure "profits", each of which has its own flaws.
Free Cash Flow & Owner's Earnings are the "best"
EBITDA & Net income are the "worst"
Free Cash Flow & Owner's Earnings are the "best"
EBITDA & Net income are the "worst"
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