In one sentence: Phil and Danielle walk through the three financial statements and the first steps of their owner-earnings formula (start with net income, add back depreciation and amortization), and defend including a judgment-heavy formula in the book.
Key ideas
- Why the formula is in the book. Danielle did not want it in because it is hard; Phil argued it makes the book unusual and shows learners can do it. It is deliberately "approximately right rather than precisely wrong". [10:00–14:00]
- A built-in test of understanding. If you can't finish the calculation, you probably don't understand the company well enough. [13:00–15:00]
- Three statements. The income statement (revenue minus expenses equals net income), the balance sheet (assets minus liabilities equals equity) and the cash flow statement, which restates net income into cash. [16:00–19:00]
- You don't need to memorize accounting. Danielle looks up which line is on which statement every time; the book's page 196 lists where each number lives. Phil's advice: still learn some accounting, since it is the language of business, for example by doing an introductory text's exercises. [19:00–23:00]
- Net income flows into the cash flow statement. It is the top line there, then adjusted for non-cash items to find the actual cash. The bottom line should match the cash in the bank. [23:00–26:00]
- Three sections of the cash flow statement. Operating (the business itself), investing (buying long-lived assets, other companies, T-bills) and financing (debt, buybacks, dividends, stock sales). Owner earnings uses operating activities and the capital expenditure line from investing; it ignores financing. [26:00–30:00]
- Add back depreciation and amortization. They were deducted for tax-style reasons and may not match real replacement cost. Buying a building that appreciates but is depreciated to zero shows the distortion. Replace the accounting number with what it really costs to keep up. [30:00–34:00]
- Example of too-low depreciation. Phil says Buffett warned that Berkshire's depreciation understated what Burlington Northern really spends on track and trains; this is his recollection, so check the letter. [33:00–35:00]
- Next step. The harder part, estimating maintenance capex, is saved for the next episode. [35:00–36:00]
- Side notes. Li Lu's remarks to Columbia MBA students are mentioned again, with Phil's point that knowing less formal accounting is no detriment if you learn it. [19:00–20:00]
How it maps to RuleOne
- On /stock/TICKER/, net income, D&A and capex are the three inputs; the filing's cash flow statement is where to check them.
- The "can't finish it" test is a quick circle-of-competence filter in the research funnel from 001.
Buffett, Munger and Graham links
- Berkshire 1986 letter for the definition; Buffett has said depreciation is a real cost in other letters (for example the 2000s discussion of EBITDA, check the year).
- Munger has called EBITDA "bullshit earnings"; not read out on this episode, so verify before quoting.
Words to know
- Cash flow statement: restates net income into actual cash from operations, investing and financing.
- Amortization: spreading the cost of an intangible asset over time.
- Financing activities: borrowing, repaying, share issuance, buybacks and dividends.
Try this
Open a company's 10-K from /stock/TICKER/. Find net income, depreciation and amortization, and capital expenditures. Compute net income plus D&A minus capex and compare it with operating cash flow.
Check yourself
- Which cash flow section does owner earnings mostly draw on?
Answer
Operating activities, plus the capex line from investing. - Why add depreciation back?
Answer
It is a tax-driven non-cash charge that may not equal real replacement cost. - What does it signal if you can't finish the formula?
Answer
You probably do not understand the business well enough yet.
Short quotes
"Accounting is the language of business." (Phil, ~21:40, auto-transcribed)