The Money That Actually Lands in Your Pocket
- Accounting profits aren’t real money — they include paper expenses that never leave the company
- Owner earnings = the cash an owner could actually take home without hurting the business
- This is Buffett’s own measure, different from what you’ll see on financial statements
- When in doubt, assume the worst case — it’s better to underestimate than overpay
The Profit Illusion
Company A reports $10 million in “profit” this year.
Sounds great, right? But what if I told you that $3 million of that “profit” was a paper expense reversal that added no cash? And the company actually had to spend $4 million replacing worn-out equipment just to keep operating?
Suddenly that $10 million “profit” doesn’t look so impressive.
This is the problem Buffett identified: accounting profit and real cash are different things. And if you want to know what a business is worth, you need to know the real cash — what he calls “owner earnings.”
What Goes in Your Pocket?
Imagine you bought a laundromat for $100,000.
Every month, customers put quarters in the machines. Some of that goes to: - Electricity bills - Water bills - Rent - Repairs when machines break
What’s left over? That’s what goes in your pocket. That’s the real profit.
Now imagine your accountant says: “Your profit is $2,000 this month.” But you look at your bank account and it only went up $1,200. What happened?
The accountant added back “depreciation” — the idea that your machines are slowly wearing out and losing value. But that’s a paper expense. No cash left the building. Meanwhile, you spent $800 on actual repairs that did leave the building.
The accounting profit was $2,000. The cash in your pocket was $1,200.
Owner earnings tries to capture the second number — what you could actually take home.
Buffett’s Formula
In 1986, Buffett explained his approach:
“Owner earnings represent (a) reported earnings plus (b) depreciation and other non-cash charges, less (c) the average amount of capital expenditures needed to maintain the business’s competitive position.”
In plain English:
Owner Earnings = Accounting Profit + Fake Expenses − Real Expenses
Where: - Accounting profit = what the company reports - Fake expenses = “depreciation” and similar paper charges that don’t use cash - Real expenses = money spent on equipment, buildings, etc. to keep the business running
The key insight: not all spending is the same.
The Two Kinds of Spending
When a company spends money on equipment or buildings (called “capital expenditures” or CapEx), it’s doing one of two things:
1. Maintenance spending — Replacing a worn-out delivery truck so operations continue normally. This is a real cost. You have to spend this money or the business declines.
2. Growth spending — Buying a second truck to expand into new territory. This is optional. If you don’t spend it, you don’t grow, but you’re still fine.
Here’s the problem: accountants lump these together. The financial statement just says “capital expenditures: $5 million.” It doesn’t tell you how much was keeping the business running vs. how much was expansion.
Owner earnings only subtracts maintenance spending — the unavoidable cost of keeping the business at its current level.
Buffett used this example: Imagine buying a business that never needed any maintenance spending. The equipment never wears out. The buildings last forever.
That would be like owning the Pyramids — “forever state-of-the-art, never needing to be replaced, improved or refurbished.”
Real businesses aren’t pyramids. Things wear out. You have to spend money just to stay in place. Owner earnings accounts for this reality.
A Simple Example
Let’s compare two businesses:
Business A (Light on Equipment):
| Item | Amount |
|---|---|
| Reported profit | $1,000,000 |
| + Depreciation (non-cash) | $100,000 |
| − Maintenance spending | $50,000 |
| = Owner Earnings | $1,050,000 |
Business B (Heavy on Equipment):
| Item | Amount |
|---|---|
| Reported profit | $1,000,000 |
| + Depreciation (non-cash) | $500,000 |
| − Maintenance spending | $600,000 |
| = Owner Earnings | $900,000 |
Both report the same accounting profit. But Business A puts $1,050,000 in the owner’s pocket, while Business B only puts $900,000.
If you valued them based on accounting profit, you’d think they’re equal. They’re not.
The Challenge: Estimating Maintenance
Here’s the hard part: companies don’t tell you how much of their spending is maintenance vs. growth.
Some approaches:
1. Use depreciation as a rough guide If a company’s equipment wears out and the depreciation number is reasonable, maintenance spending is probably similar.
2. Look at the business type - A software company? Almost no physical stuff to maintain. - A factory or railroad? Lots of equipment that needs constant upkeep.
3. Be conservative When you can’t tell, assume ALL spending is maintenance. This gives you a lower owner earnings estimate, which is safer.
Buffett’s philosophy: it’s better to underestimate owner earnings and miss some opportunities than to overestimate and overpay.
If you assume all spending is unavoidable maintenance, and the business still looks cheap, it’s probably a real bargain.
Why Wall Street Gets This Wrong
You’ll often hear analysts use “EBITDA” — Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s supposed to measure cash flow.
Buffett hates this number:
“People who use EBITDA are either trying to con you or they’re conning themselves.”
Why? Because EBITDA adds back depreciation but ignores that you actually have to replace the stuff that’s depreciating.
Charlie Munger compared it to a rental agent saying a 1,000-square-foot apartment is actually 2,000 square feet. It’s not lying exactly, but it’s definitely misleading.
EBITDA pretends equipment lasts forever. It doesn’t.
A Real World Example: Coca-Cola
When Buffett bought Coca-Cola in 1988, here’s roughly what he saw:
- Reported profit: about $1 billion
- Depreciation: about $170 million
- Capital spending: about $387 million
But Coca-Cola’s business is mostly brand and marketing — not factories. Most of that capital spending was for expansion, not maintenance.
If maintenance was roughly equal to depreciation (~$170 million):
Owner Earnings ≈ $1 billion + $170 million − $170 million = $1 billion
Pretty close to reported profit. That’s typical for asset-light businesses with strong brands.
For a railroad or airline, the gap would be much larger.
The Bottom Line
Accounting profit ≠ Cash in your pocket
Owner earnings strips away the accounting tricks to answer a simple question: “How much money could the owner actually take home each year without hurting the business?”
The formula:
Owner Earnings = Reported Profit + Non-Cash Charges − Maintenance Spending
When you can’t tell how much is maintenance spending, be conservative. Assume the worst.
Owner earnings is Buffett’s way of measuring what a business actually puts in an owner’s pocket — not what the accountants say, but what’s real.
The key insight: not all spending is equal. Maintenance spending is a true cost you can’t avoid. Growth spending is optional.
When calculating owner earnings, be conservative. Underestimating is safer than overestimating.
Next up: Part 3 — Why Buffett Ignores Wall Street Math. Wall Street uses something called “WACC” to value businesses. Buffett thinks it’s nonsense. Here’s why.
References
Buffett, W. (1986). Berkshire Hathaway Shareholder Letter. Berkshire Hathaway Inc.
Buffett, W. (2000). Berkshire Hathaway Annual Meeting. See: Wall Street Prep on EBITDA.