In one sentence: Phil and Danielle walk through the middle of the owner-earnings formula, explaining why changes in receivables and payables are added, why income tax is added back, and why the result is a pre-tax "rental property" number for the 10 cap.
Key ideas
- Owner earnings = the cash an owner could pocket. Think of a rented house: rent in, then the yearly costs and the occasional big repairs (fridge, roof, HVAC) out. Whatever is left is yours. If you can build the number, you understand the business. [01:00–05:00]
- Maintenance vs growth spending. Replacing a roof keeps the tenant; adding a mother-in-law unit grows rent. The formula wants the first kind only. [03:00–06:00]
- Receivables and payables. Receivables are what customers owe the company; payables are what the company owes suppliers. Only the year-over-year change goes into the formula. [09:00–10:00]
- The cash-timing effect. Collecting faster or paying suppliers slower frees cash; the reverse drains it. A fall in receivables or a rise in payables is a positive number, and the opposite is negative. [12:00–16:30]
- Why add them. Net income is built under accounting rules, not cash rules. The adjustments take out cash that was booked but not collected and put in cash that moved. Phil is open that he is only "six inches deep" on this and would fetch a CPA for more. [17:00–21:00]
- Buffett's wording is vague. His definition says "certain other non-cash charges"; Phil's receivables and payables lines are a deliberate, admittedly rough, stand-in for that. [11:00–13:00]
- Owner earnings vs free cash flow. Free cash flow needs no judgement but includes growth spending and taxes. Owner earnings strips both, to price the business without speculating on growth or on tax law. [24:00–28:00]
- Why taxes are added back. Tax bills swing with legislation and company-specific schedules, so removing them keeps the lens the same over decades, as with any private business. Danielle recalls Buffett saying the tax cut, not his own work, lifted Berkshire's results. [30:00–36:00]
- The farm evidence. In the 2013 letter Buffett describes buying a farm and a New York building at about a 10% pre-tax, unlevered yield. Phil infers that the 10 cap is pre-tax like real-estate cap rates, and admits accountants dispute this for public companies. [40:00–47:00]
- The formula (book p. 194): net income + depreciation and amortization + net change in receivables + net change in payables + income tax + (negative) maintenance capex. The first five come straight off the statements; maintenance capex is the art. [38:00–40:00]
How it maps to RuleOne
- The screen's owner-earnings and 10-cap figures follow this recipe; knowing which lines feed in tells you when a stock-page number looks odd.
- Danielle's habit of pulling numbers from the 10-K PDF into a spreadsheet is the check on any third-party figure on /stock/TICKER/.
Buffett, Munger and Graham links
- Buffett's owner-earnings definition: Berkshire's 1986 letter (appendix on goodwill); see 001 for the canon.
- The farm and the RTC-era building: Buffett's 2013 letter, as read out on the show.
- Treating a stock as a private business: Graham, The Intelligent Investor, chapter 8 (Mr. Market).
Words to know
- Accounts receivable: money customers owe the company.
- Accounts payable: money the company owes its suppliers.
- Cap rate: yearly pre-tax income divided by price; a 10 cap means a 10% yield.
- Unlevered yield: the return before any mortgage or debt.
Try this
Open a company you know and its latest 10-K from /stock/TICKER/. On the cash flow statement, note this year's change in receivables and payables and whether each added or drained cash. Then say in one sentence whether the business is collecting faster or paying slower than last year.
Check yourself
- Does a rise in accounts payable add or subtract in the formula?
Answer
It adds. The company is holding onto supplier cash longer, so more cash is on hand. - Why does Phil add income tax back?
Answer
Taxes vary with law and schedules; leaving them out puts every business on the same pre-tax footing, like a real-estate cap rate. - How does free cash flow differ from owner earnings?
Answer
Free cash flow is mechanical and includes growth spending and taxes; owner earnings removes both and needs a maintenance-capex judgement.
Short quotes
"Owner earnings in general are basically the money we put in our pocket." (Phil Town, ~02:30, auto-transcribed)