Cash flow absurdity and Warren Buffett’s Owner Earnings

Strength and Economic performance

Attempts to justify the unjustifiable

This is a revision of a post originally published July 28, 2025. Thanks go to Michael Ward of Ward Corporate Finance for his collaboration. See >>>Revision below.

The topic in this post is cash flow. It is such a reassuringly simple notion. Cash flow is the flow of cash into and out of a company.

And I would go so far as to say, understanding cash flow is critical for understanding the financial strength, economic performance and valuations of companies we invest in.

The problem is that company financial statements produced in accord with GAAP make the subject annoyingly difficult. As well, companies make adjustments to pull the wool over the eyes of investors. And analysts lazily tout various witless ratios as indicators of company health and value.

Financial statements

For investors the key statements are the Income Statement, the Balance Sheet and the Statement of Cash Flows.

Of these three, the only one that is truly useful for investors is the Statement of Cash Flows. Reported earnings in the Income Statement and assets reported on the Balance Sheet are largely irrelevant for investors. This is because companies that create intangible assets internally are, with certain limited exceptions, required to expense the related cash outlays. As a result, the cost of creating major long-lived corporate assets ends up reducing net or reported earnings while, at the same time, creating long-lived intangible assets that do not appear on the balance sheet. Readers needing to learn more about this might look at these posts:

Income Statements and Balance Sheets have largely lost their relevance for investors

The emergence of a new model of capitalism

The forward earnings yield another obsolete indicator

A deep dive into price earnings ratios

That leaves us with the Statement of Cash Flows

Cash flow statements

In many ways a company’s cash flow is a more intuitive concept than reported earnings. The cash flow statement sets out the company’s sources and use of cash. It deals with a specific period of time, the fiscal year. The cash flows reported are categorized as cash flow from operations, from investing and from financing.

The cash flow absurdity

Warren Buffett tells us that the cash flow numbers that are often set forth in Wall Street reports are an ‘absurdity’. He’s referring to adjusted Cash Flow from Operations, often referred to as EBITDA, earnings before interest, taxes, depreciation and amortization.

He explains that EBITDA ignores the average annual amount of capital expenditures a business is required to make to fully maintain its long-term competitive position. He notes this is always significant. If the company doesn’t invest enough in capex, the business will decay.

Buffett says: “Why, then, are “cash flow” numbers so popular today? In answer, we confess our cynicism: we believe these numbers are frequently used by marketers of businesses and securities in attempts to justify the unjustifiable (and thereby to sell what should be the unsalable). (Buffett W. E., The Essays of Warren Buffett: Lessons for Corporate America. Lawrence A. Cunningham. 1998) p186

EBITDA appeared on the investment scene many years ago. The clever rationale was that it enabled investors to compare the profitability of companies with similar business models regardless of their capital structure and use of debt. Companies and analysts jumped on it like a dog on a bone.

Let’s look at the Cash Inflows from operations side of it first

To come up with a number for cash inflows from operations you need to figure out the Cash from Operating Activities. This is a term defined by GAAP, the Generally Accepted Accounting Principles. Cash from Operating Activities is calculated by adding Depreciation and Amortization back to Net Income from the Income Statement as well as changes in Accounts Payable and Receivable. To see this, look at this upper portion of a Cash Flow Statement from Veeva Systems Inc., a provider of cloud solutions for the global life sciences industry. This is just the upper part of the Cash Flow Statement. In my screenshot I just grabbed the 2022 yearend rather than the three-year history. The lower part of the Cash Flow Statement (not shown) deals with cash flows in and out from the company’s investing and financing activities.

As you can see, you start with Net Income and adjust for Depreciation, Deferred Taxes, Non-Cash Items and Changes in Working Capital. As I say, adjusting for these items gives you a number for cash inflows.  These are all legitimate adjustments.

If you add back Interest Expenses and Income Taxes incurred you get EBITDA, earnings before interest, taxes, depreciation and amortization. This is the “absurdity” referred to by Buffett above.

EBITDA is not recognized by GAAP. The U.S. Securities and Exchange Commission (SEC) requires listed companies reporting EBITDA figures to show how they were derived from net income, and it bars them from reporting EBITDA on a per-share basis.

The sin of adjusted EBITDA

But it gets worse. To these ‘legitimate’ adjustments we can add the illegitimate adjustments. Warren Buffett can explain.

“Despite our recent additions to marketable equities, the most valuable grove in Berkshire’s forest remains the many dozens of non-insurance businesses that Berkshire controls (usually with 100% ownership and never with less than 80%). Those subsidiaries earned $16.8 billion last year. When we say “earned,” moreover, we are describing what remains after all income taxes, interest payments, managerial compensation (whether cash or stock-based), restructuring expenses, depreciation, amortization and home-office overhead.

That brand of earnings is a far cry from that frequently touted by Wall Street bankers and corporate CEOs. Too often, their presentations feature “adjusted EBITDA,” a measure that redefines “earnings” to exclude a variety of all-too-real costs.

For example, managements sometimes assert that their company’s stock-based compensation shouldn’t be counted as an expense. (What else could it be — a gift from shareholders?) And restructuring expenses? Well, maybe last year’s exact rearrangement won’t recur. But restructurings of one sort or another are common in business — Berkshire has gone down that road dozens of times, and our shareholders have always borne the costs of doing so.

Abraham Lincoln once posed the question: “If you call a dog’s tail a leg, how many legs does it have?” and then answered his own query: “Four, because calling a tail a leg doesn’t make it one.” Abe would have felt lonely on Wall Street.” 2018 Berkshire Hathaway Annual Letter (Emphasis Added)

Where does that leave us?

Most analysts will talk of EBITDA, EBIT, NOPAT and what not. Warren Buffett’s approach is to think in terms of Owner Earnings. It is somewhat akin to free cash flow.

Owner earnings

The basic idea of Owner Earnings is that superb businesses generate far more cash than they can use internally. This is Owner Earnings. The value of Owner Earnings to shareholders depends on how effectively this cash is deployed by management – capital allocation.

The concept of Owner Earnings is Warren Buffett’s invention. In his 1986 Chairman’s letter to the shareholders of Berkshire Hathaway, Buffett included a lengthy discussion of the purchase-price adjustments made on the balance sheet of a business they had acquired as a result of paying a premium of $142 million over book value!! The adjustments Buffett made resulted in changes to the balance sheet and also the income statement. Buffett pondered the question as to what all this meant to the shareholders.

Buffett writes:

“If we think through these questions, we can gain some insights about what may be called “owner earnings”. These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume….

Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since(c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”” (Emphasis added)

{{ I note as an aside that this quote from Keynes is one of the most profound observations in investing. The world is inherently uncertain. Sadly, for the positivists and quants of this world, there are many important things that cannot be counted precisely.}}

Rather than deducting what the company happened to spend in one year or even average five years capital spending, Buffett makes an assessment as to the capital spending necessary to maintain the company’s competitive position. This may leave substantially less free cash than typical calculations of Free Cash Flow produce.

It is Owner Earnings that Buffett uses to judge the performance of the company and its management. It is also Owner Earnings that Buffett uses to assess the intrinsic value of a company.

One other point

There is a mix-up in current accounting rules that twists the Statement of Cash Flows.

Michael Mauboussin and Dan Callahan wrote in an April 2021 edition of Counterpoint Global Insights about how to bridge accounting and valuation practice when company investments in intangibles of lasting value reduce reported income but do not appear as investments on the Statement of Cash Flows.

They conclude: “This report fills the gap between accounting and valuation by defining MEROI [market-expected return on investment], providing guidance about how to separate SG&A costs into investment and expenses, and reviewing the limitations of popular measures of return. None of this changes a company’s cash flow, of course, but clarity into investment and return on investment provides a sound basis for assessing expectations.”

Where this leaves us

Generally, the higher the free cash flow the better. But, many companies with lower free cash flow are better investments. That’s because the cash is deployed in growing the business. See my post: Back to basics about free cash flow

Cash flow is important in valuing companies. See my post: Heart of stock valuation: subtleties of free cash flow

We live in a strange world when there can be good losses and bad losses and when companies that make GAAP losses can be better investments that those that make GAAP profits. See my post: Negative free cash flow can be desirable

>>>Revision: The theme of above post is that understanding cash flow is critical for understanding the financial strength, economic performance and valuations of companies we invest in. But with the proviso that company financial statements produced in accord with GAAP make the subject annoyingly difficult. Michael’s thought is that a detailed comparison between Owners’ Earnings and EVA would be very interesting. He says both have a broadly similar approach of focusing on truly economic free cash flow, but EVA seems to be more robust and less subjective in achieving this.

Let me offer a few thoughts:

First, let me take the definition of EVA from Wikipedia.

“Economic value added (EVA) is an estimate of a firm’s economic profit, or the value created in excess of the required return of the company’s shareholders. EVA is the net profit less the capital charge ($) for raising the firm’s capital. The idea is that value is created when the return on the firm’s economic capital employed exceeds the cost of that capital, and equally if the return is less than the cost of capital, the firm is operating at a loss. The value of EVA can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments, although in practice there are several key ones are made, depending on the company and its industry.” (Emphasis added)

EVA is calculated using the formula: EVA = NOPAT – (Invested Capital * WACC), where NOPAT is the net operating profit after taxes. (Investopia)

The first rub – adjustments. One cannot simply plug in numbers from a financial statement. Operating Profit after taxes is reduced by companies expensing investment in intangibles of lasting value that should really be capitalized. This artificially reduces Operating Profits.

The second rub is that Invested Capital is distorted in the modern intangible company. Most company investment today, of lasting value, is in intangibles that do not appear on the balance sheet. This seriously warps the dollar amount of Invested Capital.

Lastly, WACC is the weighted average cost of capital. The cost of debt capital is simple enough to determine. The cost of equity is derived from the Capital Asset Pricing Model (CAPM). This is a formula dependent on the rate of return that investors demand based on the expected volatility of the stock. If this sounds weird, it is. It is wholly dependent on the idea that risk equals volatility, which it doesn’t.

I am not a fan of EVA.

With Warren Buffett’s Owner Earnings, I make a business analysis rather than a financial analysis. I look at five years of Operating Cash Flow, five years of Capital Spending and five years of Free Cash Flow and how they have grown over the years (growth) and think about the opportunities the company has to invest free cash flow in the future to continue to grow. This is done by inspection rather than by calculation or quantification.

Having said that, I think EVA can be used as a screening tool to come up with a list of companies to investigate further, including by looking at Warren Buffett’s owner earnings.

Thank you, Michael, for stimulating these further thoughts. End Revision<<<

Conclusion

Reported earnings and balance sheets are largely obsolete for investors. A company’s Operating Cash Flow can be useful as long as you know what adjustments have been made by analysts. Have they added back in interest costs and taxes, which of course use up cash (EBIT)? Are they using EBITDA to show the cash flow of the company without pointing out necessary expenditure for capital expenses?

Cash flow is important in assessing the financial strength of a company. Does it have to cash flow to pay off its debt quickly? It is also important in assessing the economic performance of a company. What is its return on capital invested? Finally, it is important in estimating the intrinsic value of a company. We use a discounted cash flow analysis.

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