In one sentence: Once the meaning, moat and management checks say a business is wonderful, you price it with the ten cap, and Phil now calculates owner earnings as operating cash flow minus maintenance capital spending plus the tax provision.
Key ideas
- Checklists fail when skimmed. Phil's analysts sometimes write facile answers, and an outside reader sees glaring holes. Have someone who doesn't share your view read it, and be able to explain the business in three sentences. [00:00–06:00]
- A gate before valuation. If the business is not understood and wonderful after the meaning, moat and management steps, stop. There is no point valuing it. [06:00–08:30]
- Three views of price. The checklist covers the ten cap, payback time and a discounted cash flow, all aimed at a margin of safety. This episode covers only the ten cap. [08:00–10:00]
- Checkpoint 1: be highly confident the business will be larger and more productive in 10 years. Phil compares it to a rental house near Atlanta, where growth gives him confidence rents will be higher. Chipotle (100 to 200 new stores a year from free cash flow, plus drive-through and catering) is his business example. If this box is checked, put it on the watch list; the rest is waiting for a sale. [09:00–14:00]
- Checkpoint 2: new owner earnings formula. The book's formula (net income plus depreciation and amortization, plus changes in receivables and payables) was an attempt to imitate Buffett's 1986 definition. Phil's CPA friends say to use operating cash flow instead, which already includes working capital. Danielle, who found the old formula clumsy, is pleased. [14:00–19:00, 35:00–36:00]
- Checkpoint 3: use a reasonable operating cash flow. Look at several years so you don't build the ten cap on an unusually good (or bad) year. A lifted outlier can make you overpay. [19:00–22:00]
- Checkpoint 4: maintenance capex. Companies rarely split capital spending into maintenance and growth. Phil's CPAs studied companies and found maintenance is 20 to 80% of capex, so the toolbox will default to 50% unless the 10-K or the business (a railroad, say) says otherwise. Chipotle's disclosed figure of $57 million in one 10-K year is used when available. Danielle objects that a default is an escape from understanding the company; Phil replies that the margin of safety covers an error. [22:00–28:30]
- Checkpoint 5: add back the tax provision. The result is a pre-tax number comparable to a rental house or farm. Formula: operating cash flow − maintenance capex + tax provision = owner earnings. [28:30–32:00]
- Why a ten cap. Ten percent owner earnings on the price is a high bar; it builds in room for error. Phil says Apple's owner earnings yielded about 11% when he bought near $90, though that was theoretical because Apple would not pay it out. [29:00–34:00]
- Could I pocket it? The last checkbox: if I owned the whole business, could I really take out the owner earnings without damaging it? Using operating cash flow answers the working-capital worry. [32:00–36:00]
- Missing conclusion. The pair agree the checklist needs a final line after all three valuation methods, such as being confident enough to put a large share of net worth into the business, and that this should rest on all three views (triangulation), not one. [36:00–39:30]
How it maps to RuleOne
- Check how the site's valuation computes owner earnings and maintenance capex before relying on it. The episode's formula (operating cash flow, less maintenance capex, plus tax) may differ from what the site uses. Look at the stock pages and the valuation code before assuming they match.
- A ten cap is the "10% yield" test: price × 10% must be at most owner earnings.
Buffett, Munger and Graham links
- Owner earnings is from Buffett's 1986 Berkshire letter, as Phil says here.
- A margin of safety to absorb mistakes is Graham's core idea (The Intelligent Investor, ch. 20).
Words to know
- Ten cap: price at which owner earnings are 10% of the price.
- Operating cash flow: first main line on the cash flow statement: cash generated by operations.
- Maintenance capex: spending needed to keep the business running at its current level, as opposed to growth spending.
- Tax provision: the income tax line on the income statement, added back here to get a pre-tax figure.
Try this
Pick a company at /stock/TICKER/. Take operating cash flow for five years, choose a typical year, subtract half of capital expenditures, add the tax provision, and divide by the share count. Multiply by 10 for a ten cap price and compare it with today's price.
Check yourself
- What is the new owner earnings formula?
Answer
Operating cash flow, minus maintenance capital expenditures, plus the tax provision. - What default does Phil use for maintenance capex when nothing is disclosed?
Answer
50% of total capex, within a studied range of 20 to 80%. - Why not base the ten cap on the best year's cash flow?
Answer
An unusually good year can inflate value and lead you to overpay.
Short quotes
"Highly confident that this business will be larger and more productive in 10 years." (Phil, ~09:30, auto-transcribed)