Free Cash Flow

Free Cash Flow defined as:

For all intents and purposes we use the Warren Buffett’s definition of Owner’s Earnings for Free Cash Flow.

Free Cash Flow considers cash charges as they are applied.

Reported earnings + depreciation, amortization, other non-cash items – average annual amount of capitalized spending on plant, machinery, equipment (and presumably research and development).

The standard definiton of FCF is:

FCF = Cash from Operations – Capex

The gist is if we owned all of the business what would we end up with in terms of cash after running our business for the year. We consider all cash items that are capital expenditures but subtract away all non cash charges that represent a fixed percentage of amounts spent in the past like Depreciation, or things that represent economic goodwill like Amortization.  

Buffett on Owner’s Earnings

What Warren Buffett refers to as Owner’s earnings is also known as free cash flow but should not be confused with the proliferating “cash flow” which ignores capital expenditures. A concept defined by Warren Buffet in his 1986 Chairman’s Letter (edited for simplicity):

These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such 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. (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.)

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.”