What are Owner Earnings?

And why you should consider them over Free Cash Flow

I often talk about Owner Earnings in my work because I find Free Cash Flow to have some serious flaws, so let’s discuss it!

Owner Earnings = Free Cash Flow + Growth CapEx - Stock-Based Compensation +/- Changes in Net Working Capital

What’s Free Cash Flow?

Free Cash Flow (FCF) was my preferred way to value businesses for a long time. There are various ways to calculate Free Cash Flow, mostly differentiating between Operating Cash Flow and NOPAT, but I use the most commonly used variant, as shown below.

Free Cash Flow = Operating Cash Flow - CapEx

FCF represents all cash that flows into the business after reinvesting everything back into the business. This means that dividends, buybacks, debt payments and acquisitions are all paid with FCF. This is a big advantage to classic earnings/net income, as it does not include non-cash charges like restructuring costs, depreciation and amortization (D&A), or write-downs. This makes it harder to distort or, worse, manipulate FCF compared to net income. However, I hope to combat the downsides of FCF using Owner Earnings.

Distortions of Free Cash Flow

There are three main ways to distort FCF:

1. High growth CapEx spending

2. Stock-based compensation (SBC)

3. Changes in Net Working Capital (NWC)

High-growth CapEx spending

Standard FCF subtracts all CapEx from OCF; this can be a large error in valuing a business. Often, businesses spend CapEx to grow the business, an expense that can be cut and paid out to shareholders if wanted. We need to differentiate between growth CapEx and maintenance CapEx. As the name implies, maintenance CapEx is required to operate the business as it is and can not be cut.

The tricky part is that most companies don’t share which part of CapEx is for growth. If we’re lucky, we find information, like in the picture below from Alimentation Couche-Tard. We can conclude that the Stay in Business part represents maintenance and the remaining 75% is growth. A proxy I use to estimate maintenance CapEx is D&A expenses. Using the proxy we have the following formula

Growth CapEx = Total CapEx - D&A expenses

This doesn’t always make sense, but it can be a good guideline. I’d always be conservative and opt for lower growth CapEx in a model so as not to be exuberant. Another issue with this approach is that it is just theoretical cash flow that COULD be returned, but we have no guarantee.

Stock-based compensation (SBC)

Stock-based compensation (SBC) has been abused horrendously by some companies over the last few years. Because SBC is not a cash expense, it is added back to FCF. Many companies use this tactic to pay a large part of employee compensation in stock to show higher FCF. Below is some data for Salesforce CRM 0.00%↑; we can see that SBC is a substantial part of FCF. We also see that Salesforce significantly diluted the shareholders. Last year, they pivoted and started to return capital to shareholders via buybacks. I hate this term and find it dishonest. Salesforce gives out $3.28 billion in stock and then repurchases $4 billion. In my opinion, that is a $0.72 billion capital return and not $4 billion. Dilution erodes your ownership in a company and thus should be seen as a cost for shareholders.

There is nuance to it and a dollar of SBC doesn’t translate to a dollar of issued stock. These are mostly options, and not all of them will be exercised. Calculating is very tough, so I keep it simple and subtract all SBC. This also helps me stay conservative. On the downside, this might make some Software businesses look more expensive than they are.

Changes in Net Working Capital (NWC)

The last adjustment I make are changes in Net Working Capital. NWC is capital tied to the business and required to operate. The main components are Inventories, Accounts Payable and Accounts Receivable. These can significantly distort FCF and make a company look very cheap or very expensive.

Below is the example of Watsco WSO 0.00%↑, where we can see how changes in inventories cut FCF in half in early 2022. FCF dropped to $256 million, while Changes in Inventories over the last 12 months were $312 million. Over the business cycle, these NWC changes mostly, even themselves out, so I prefer to adjust them to get a more steady state view of cash flows.

A risk with this approach is that it can ignore long-term trends. For example, some businesses have an ever-increasing level of inventories due to store network expansion. At that point, it becomes a recurring situation. On the other hand, some companies continually optimize supplier payments and push their own payments out further or get supplier payments sooner, thus creating a negative Working Capital business. These trends can be part of an investment case and would be ignored by simply adjusting it. I believe the benefits outweigh, but one has to be aware of the danger.

Conclusion

Let’s look at an example where there is a large difference between FCF and Owner Earnings. The example below is part of my inverse DCF model of Alimentation Couche-Tard $ATD. We can see that FCF is just $2.5 billion, while Owner Earnings are $4.3 billion. Compared to enterprise value, it trades at a 3.9% FCF yield or 6.7% owner earnings yield—quite the difference. I arrived at the $1.392 billion in growth CapEx by subtracting 25% maintenance CapEx from total Capex (remember the slide I shared earlier?) and we can also see $438 in NWC changes, which suppressed FCF in the last twelve months. SBC is not a large issue at $28 million, but we adjust it anyway.

I believe that Owner Earnings gives us a better picture of the actual cash flows of a business, compared to its Free Cash Flow and I’d recommend always thinking about the metric you use to evaluate a business. My version of Owner Earnings has flaws, but it is a good approximation of value.

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