Owner earnings run rate is an extrapolated estimate of an owner’s earnings (free cash flow) over a defined period of time—typically a year.
Key Benefits
- Provides an estimate of an owner’s earnings (free cash flow) over a defined period, usually a year.
- Indicates the actual dollar value a company is expected to generate and have available for expenditures, based on current financial data.
- Assumes consistent financial performance, making it less applicable to businesses with variable revenue streams.
Understanding Owner Earnings Run Rate
Owner earnings run rate is derived from two components: owner earnings and run rate. Let’s dive into what each term means.
Run Rate
The run rate is a forecasting method relying on past data to predict future financial performance. For instance, if a company records revenue of $100 million in its last quarter, this can suggest an annual run rate of $400 million based on current trends.
Owner Earnings
Owner earnings is a valuation method championed by investor Warren Buffett. Unlike net income, which may not fully reflect a business’s available dollars, owner earnings offer a clearer picture of the cash surplus that can be distributed to owners and increase shareholder value.
Bufett explained it as follows:
“Owner earnings represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges minus the average annual capitalized expenditures required to maintain company operations.”
In simplified terms:
Owner earnings = reported earnings + depreciation & amortization +/- non-cash charges - maintenance capex +/- changes in working capital.
Analyzing Owner Earnings Run Rate
Owner earnings provide insights into the amount of value a company creates and how much of this flows back to shareholders. These earnings often end up approximating free cash flow, which illustrates the cash generated after accounting for cash outflows required for operational support and asset maintenance.
Pros and Cons of Owner Earnings Run Rate
Advantages
- Essential for evaluating a company’s financial health and performance.
- Increased owner earnings often indicate future business growth and profitability.
- An accurate estimate could significantly inform and enhance long-term investment strategies.
Disadvantages
- Relies on assuming consistent financial performance, which isn’t suitable for businesses with seasonal sales or irregular revenue patterns.
- May not account for spikes in earnings due to new product launches or one-time sales.
Crucial Insight
Owner earnings run rate may be less accurate when applied to companies experiencing varied financial performance between quarters.
Related Terms: free cash flow, net income, depreciation, amortization, working capital.
References
- Berkshire Hathaway Inc. “Annual Shareholder Letter, 1986”.
