Author: Ben Tewey

Published: 5/14/21

In order to understand owner earnings it is best to use a thought experiment. As the weather warms up and summer hits the east coast I have been going to microbreweries more often so let this be our example. 

An Example

Pretend you are opening a brewery: VestBrew in a nice open location, great scenery, huge open plot and you rent out this land for 7 thousand a month including utilities. Of course, the place must then be decorated with seating both indoor and outdoor, lights and other amenities. This sums to 100 thousand and they will last you ten years. Next, you have to buy various equipment kettles, kegs, fermentation tanks and storage which sets you back 80K and you have to replace them every 4 years. Lastly, you have to buy supplies: wheat, water, napkins, and plastic cups which will cost you 40K a month. 

A year has gone by and you are running a terrific operation. Make no mistake, VestBrew was a success selling $1 million in craft beverages! 

So how much money did you earn in your first year? Well 1M- 594K=406K.

Being the prudent business person you are, you immediately pay your 20% tax (81.2K) to Uncle Sam. Therefore leaving you with a net income of 324.8K. 

Now let’s say you have a checking account where you’ll keep all your profits. At the beginning of the period you put 3 months worth cash to pay for your expenses. Therefore you will have 3*(7K rent+40K supplies)=141K. However, you will not have 141K initial +324.8K net income=465.8K in the account. 

In fact, the checking would have grown to 515.8K because of the 324.8K net income+141K initial savings+30K depreciation. This “extra” 30K is because net income included a “non cash” charge called depreciation or general wear and tear on your equipment and furniture. This is indeed a real cost to you, the owner, but just not in that first year. But you will be feeling that expense when you have to replace your equipment in 3 years. 

Now the question becomes, how much money can you remove from the business into your own checking account without hurting the business? You need to be prepared for a bind and you keep the 3 months of expenses in the account (141K) and let’s say we have some inflation so the equipment that was 80K is now 90K three years later and the furniture that was 100K is now 180K in 9 years. So you put away 15K (¼ of the 90K you need every 3 years) and 18K (1/10 of the 180k you need in 9 years. So in total it will be 33K capital expenses plus the 141K operating expenses=174k. 

Remember your checking account has 515.8K. So 515.8K-174k=341.8K. This 341.8K is called your “owner earnings.” This number is different from net income, operating cash flow, and free cash flow. It helps investors think like an owner, exactly what they become when they buy stock in a company. Owner earnings are an estimate of how much cash it takes to maintain a business’s earning power and puts investors in the right frame of mind to think like a business person. In the words of Ben Graham, “Investment is most intelligent when it is most businesslike.”

Bibliography

10K Diver Thread on Owner Earnings 

Buffett Letter to Shareholders 1986

Graham, Benjamin. Essay. In The Intelligent Investor, edited by Jason Zweig, 512–31. New York, NY: Harper, 2006.