Why Cash Flow Matters More Than Earnings

In 1986, Warren Buffett introduced a concept that would change how serious investors evaluate businesses. He called it "owner earnings" — and it had almost nothing to do with the earnings number reported on income statements. Owner earnings, Buffett explained, represent the cash a business actually generates for its owners after all necessary reinvestment. It's the money you could theoretically extract from the business without impairing its competitive position.

Why does this distinction matter? Because reported earnings are an accounting construct, subject to dozens of management choices that can inflate or deflate the number without changing the underlying economic reality. Depreciation schedules, revenue recognition timing, stock-based compensation treatment, one-time charges, and restructuring costs all create a gap between reported earnings and actual cash generation.

Consider two companies, both reporting $100 million in net income. Company A generates $150 million in operating cash flow and spends $30 million on maintenance capital expenditures, yielding $120 million in free cash flow. Company B generates $80 million in operating cash flow and requires $60 million in capital expenditures just to maintain its operations, yielding only $20 million in free cash flow. The income statements look identical. The cash flow statements reveal radically different businesses.

Charlie Munger put it memorably: "There are two kinds of businesses. The first earns 12% and you can take the profits out at the end of the year. The second earns 12% but all the excess cash must be reinvested — there is never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business."

The free cash flow yield — free cash flow divided by enterprise value — is one of the most powerful yet underused valuation metrics. A company trading at a 7% free cash flow yield is, in essence, offering you a 7% annual return in real cash, with any future growth as a bonus. Compare this to the earnings yield, which may include significant non-cash components that never reach your pocket.

How do you calculate owner earnings in practice? Start with net income. Add back depreciation and amortization. Subtract maintenance capital expenditures — the spending required just to maintain the current earning power, not to grow the business. The result approximates what the owner actually receives.

The tricky part is distinguishing maintenance capex from growth capex. Companies rarely disclose this split. You have to estimate it by analyzing capital spending patterns relative to revenue growth, reading management commentary about capacity expansion versus replacement, and comparing capex to depreciation over multiple years.

Industries differ dramatically in their cash flow characteristics. Software companies often have minimal capital expenditure requirements, meaning nearly all their earnings convert to cash. Airlines, by contrast, require enormous ongoing investment in aircraft, resulting in cash flows far below reported earnings. This explains why software companies command premium valuations — their earnings quality is fundamentally superior.

Red flags to watch for include: growing earnings accompanied by declining operating cash flow, a persistent gap between net income and cash from operations, heavy reliance on working capital changes to boost cash flow, and frequent "one-time" charges that somehow recur every year.

Joel Greenblatt's "Magic Formula" investing approach uses earnings yield as a key metric, but savvy practitioners substitute free cash flow yield for even better results. The modification eliminates capital-intensive businesses with deceptively high earnings but low actual cash generation.

At KeepRule, we emphasize that understanding cash flow is not about complex financial modeling. It's about asking one simple question: does this business generate real cash that I, as an owner, could spend? If the answer is consistently yes, and the price is reasonable relative to that cash flow, you've found a business worth owning.

The next time you evaluate an investment, skip the earnings per share headline and go straight to the cash flow statement. The truth about a business's economic engine is always found in the cash — never in the accounting.