What Is Owner Earnings Run Rate?

Owner earnings run rate is an extrapolated estimate of an owner's earnings (free cash flow) over a defined period of time — typically a year. 

Key Takeaways

  • Owner earnings run rate is an extrapolated estimate of an owner's earnings (free cash flow) over a defined period of time—typically a year. 
  • It tells us the actual dollar value a company is expected to produce and have available to spend, using current financial data.
  • Owner earnings run rate assumes that a company’s financials stay consistent, though, so it cannot be applied to businesses with lumpy revenue streams.

Understanding Owner Earnings Run Rate

Owner earnings run rate is a term made up of two separate components: owner earnings and run rate. To understand how it works, it is first necessary to get to the bottom of what each of them mean.

Run Rate

The run rate is a method for forecasting the future financial performance of a company based on past data. Let’s say a company records revenue of $100 million in its last quarter. Using this information as a predictor of future performance, we could say that it is expected to register sales of $400 million for the year—or is operating at a $400 million run rate. 

Owner Earnings

Then there’s owner earnings: a valuation method favored by investment guru Warren Buffett. Net income (NI) gets a lot of attention from investors, yet does not always fully reflect the actual dollar amount that a business has in its coffers to distribute to owners and boost shareholder value.

That’s what owner earnings sets out to achieve. Buffett stated that the value of a company is simply the total of the net cash flows (owner earnings) expected to occur over the life of the business, minus any reinvestment of earnings. In a 1986 Berkshire Hathaway Annual Shareholder Letter, Buffett gave some insight into owner earnings and how it should be calculated:

"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 such as Company N's items (1) and (4) less 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. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)"

In other words, owner earnings = reported earnings + depreciation, amortization +/- other non-cash charges – average annual maintenance capex +/- changes in working capital. What the resulting figure aims to tell us is the amount of value the company is creating and how much is flowing back to shareholders. Often, it ends up similar to free cash flow (FCF): the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. 

Advantages and Disadvantages of Owner Earnings Run Rate

Owner earnings is an important metric that investors can use to gauge a company’s financial health. Increased owner earnings tend to act as a signal that a company's subsequent earnings will be good. Therefore, assessing an accurate owner earnings run rate could be very important in predicting the company's longer-term performance.

The problem is that the owner earnings run rate is not always reliable, namely because it takes for granted that the company’s financial performance stays consistent throughout the period. For example, let’s say that after three quarters a company posts owner earnings of $9 million. Assuming that performance stays consistent, the company's owner earnings run rate for the fiscal year (FY) would be $12 million ($3 million per quarter).

This estimate can be difficult to assess if the company is operating in an industry that experiences seasonality. In such cases, owner earnings from one period may not be applicable across the entire time period.

Important

The owner earnings run rate is flawed when applied to companies whose financial performance fluctuates from quarter to quarter.

Run rates do not account for higher sales linked to a new product release, a common occurrence among many technology firms, or large, one-time sales, either.