Methodology
Owner earnings and earnings power
Reported profit is not the cash an owner could take out. Here is the gap, how earnings power closes it, and how it compares with free cash flow.
What an owner could take out
An owner of a whole business cares about one figure above all: how much cash it could hand over each year while staying exactly as competitive as it is today. Value investors call that owner earnings.
Reported net income misses it in both directions. Depreciation is charged against profit but is not cash; capital spending is cash but is not charged against profit. What matters is the spending needed just to stand still.
Maintenance versus growth
Capital spending has two jobs. Maintenance keeps today's business running: replacing worn equipment, refreshing stores, keeping systems current. Growth spending builds more business. Only the first is a cost of today's earnings; the second is an investment in tomorrow's.
Filings rarely split the two, so it has to be estimated. StockValuer's estimate follows Bruce Greenwald: the plant and equipment needed to support the year's growth in sales, at the business's existing ratio of plant to sales, counts as growth spending, and the rest of capital spending counts as maintenance. In a year when sales fell, all of it is maintenance. A company that discloses its own maintenance figure is taken at its word.
Earnings power
Earnings power is the owner-earnings idea made repeatable: sales and margins normalized over several years so one good or bad year does not dominate, operating profit taxed at a normalized rate, depreciation added back and maintenance spending taken off. The result is what the business would generate each year with no growth spending at all.
Beside free cash flow
Free cash flow is what was actually left after all capital spending, growth included. A company investing heavily in growth shows free cash flow below its earnings power; that gap is the reinvestment, not a weakness in itself. Free cash flow above earnings power can mean spending was held back below what upkeep needs.
The Overview's “Is it a good business?” chapter states the two side by side for each company, the normalized earnings power and the latest year's free cash flow, so the reader can see which way the gap runs.
Terms in this guide