What is the Owner Earnings Run Rate?
Owner earnings run rate is an extrapolated estimate of the cash flow available to owners over a defined period (most commonly a year) based on recent owner‑earnings figures. It combines two ideas:
– Owner earnings — a measure (favored by Warren Buffett) intended to approximate the actual cash available to owners after essential reinvestment; and
– Run rate — the practice of annualizing (or otherwise projecting) a recent period’s result to estimate performance over a longer period.
Why it matters
Owner earnings aim to show the cash a business really generates for owners (more informative than reported net income alone). Annualizing those owner earnings (the run rate) gives a quick forecast of how much cash the company may produce over a year if recent conditions persist. Investors use the metric for valuation, dividend/buyback sustainability checks, and comparing cash generation across companies.
Formula (conceptual)
Owner earnings (period) ≈ Reported earnings (net income)
+ Depreciation & amortization (non‑cash charges)
+ Other non‑cash charges
− Average annual maintenance capital expenditures (maintenance capex)
± Change in working capital (use sign convention described below)
Common sign convention for working capital: if working capital increases (more cash tied up), subtract the increase; if working capital decreases (cash freed), add the decrease.
Owner earnings run rate = Owner earnings (recent period, e.g., quarter or TTM) annualized to the desired horizon (e.g., ×4 for one quarter to a year, or use trailing‑12‑month sum).
Step‑by‑step: How to compute owner earnings run rate (practical)
1. Choose the period to base the run rate on
– Prefer trailing‑12‑months (TTM) where possible; if using a single quarter, be careful about seasonality.
2. Gather items from the financial statements
– Net income (income statement)
– Depreciation & amortization and other non‑cash charges (income statement / cash flow statement)
– Capital expenditures (cash flow from investing) — you’ll separate maintenance capex from growth capex (see step 4)
– Working capital components (current assets minus current liabilities) to compute the change in working capital over the period.
3. Compute owner earnings for the chosen period
– Owner earnings = Net income + D&A + other non‑cash charges − maintenance capex ± change in working capital.
4. Estimate “maintenance” portion of capex
– Many firms report total capex; analyst judgment is needed to split between maintenance (to sustain current operations) and growth (to expand capacity). Approaches:
– Use historical average capex in stable periods as proxy for maintenance.
– Use company disclosures or management comments.
– Capitalize on industry rules of thumb (e.g., replacement rates).
– If uncertain, present a range (low/high maintenance capex) and show sensitivity.
5. Annualize the result (run rate)
– If you computed owner earnings for one quarter, multiply by 4 for a simple annual run rate.
– If you used TTM owner earnings, the run rate is the TTM number (the best practice for seasonality).
– If growth or contraction is expected, adjust the run rate with a justified growth assumption rather than blind annualization.
6. Check and adjust for one‑offs and seasonality
– Remove one‑time gains/losses and non‑recurring items to get a normalized owner earnings figure.
– For seasonal businesses, avoid extrapolating a single quarter; use TTM or seasonally adjust.
7. Sensitivity analysis
– Show owner earnings run rate under multiple maintenance capex and growth scenarios to capture uncertainty.
Worked (simple) example
Assume a company’s most recent quarter shows:
– Net income = $5.0M
– D&A = $1.5M
– Other non‑cash charges = $0.2M
– Total capex = $1.0M (analyst judges maintenance capex ≈ $0.6M)
– Change in working capital this quarter = −$0.2M (i.e., working capital decreased, so cash freed)
Quarterly owner earnings = 5.0 + 1.5 + 0.2 − 0.6 + 0.2 = $6.3M
Annualized (simple run rate) = $6.3M × 4 = $25.2M
If you instead use TTM numbers (sum of last four quarters) you avoid some seasonality issues and one‑quarter anomalies.
Advantages
– Focuses on cash available to owners—often a better indicator of value than net income alone.
– Aligns with free cash flow concepts and investment valuations (owner earnings approximates FCF after necessary reinvestment).
– Simple to compute and communicates a straightforward, cash‑focused perspective.
Limitations and pitfalls
– Run‑rate extrapolation assumes recent performance will continue; this is unreliable for seasonal, cyclical, or rapidly changing businesses.
– Owner earnings requires estimating maintenance capex, which is not usually disclosed separately; different assumptions materially change the result.
– One‑time items, restructuring charges, or large timing differences in working capital can distort short‑term owner earnings.
– For high‑growth companies with heavy growth capex, owner earnings may be low (or negative) even when future cash flows are large—so context matters.
When to use — and when not to
Use owner earnings run rate when:
– You want a cash‑centric measure to assess valuation, dividend sustainability, or buyback capacity.
– The company is mature and relatively stable in operations and capital spending.
Avoid or use with caution when:
– The business is highly seasonal, cyclical, or undergoing rapid structural change.
– The company has lumpy or unpredictable capex and working capital swings.
Practical checklist for analysts
– Prefer TTM owner earnings rather than single‑quarter annualization unless you have a seasonally neutral quarter.
– Explicitly disclose and justify assumptions about maintenance capex.
– Remove or explain one‑time items and extraordinary charges.
– Present a sensitivity table showing owner earnings run rate under alternative maintenance‑capex and growth assumptions.
– Compare owner earnings run rate to reported free cash flow (FCF) and investigate significant differences.
– Look at multi‑period trends in owner earnings (last 3–5 years) to see sustainability and direction.
Red flags to watch for
– Large discrepancy between owner earnings and reported FCF without clear explanation.
– Management commentary that contradicts your maintenance capex assumptions.
– Rapid, unexplained swings in working capital.
– Reliance on a single quarter’s owner earnings for annual forecasts in seasonal businesses.
How investors use the metric in practice
– Valuation: Discount owner‑earnings‑based cash flows as an alternative to FCF in DCF models.
– Dividend/buyback assessment: Check whether owner earnings support distribution plans.
– Asset allocation: Comparing cash generation across companies or sectors where reported earnings are less informative.
Further reading / sources
– Warren Buffett, Berkshire Hathaway Annual Shareholder Letter, 1986 (Buffett popularized the term “owner earnings” and outlined the conceptual formula).
– Investopedia, “Owner Earnings Run Rate” (overview and examples).
Summary
Owner earnings run rate is a useful, cash‑focused way to estimate how much cash a business is likely to produce for owners over a future period based on recent owner earnings. It is most valuable when computed carefully (TTM preferred), with transparent assumptions about maintenance capex and one‑offs, and when used alongside sensitivity analysis to reflect the inherent uncertainty in any run‑rate extrapolation.