Buffett: owner earnings and the economic moat
Warren Buffett asks two things about every company: what does it really earn for its owners? And how well is that income protected from competition? Owner earnings answer the first question, the moat the second – a lasting advantage that others cannot simply copy.
What a company really earns
In his 1986 letter to shareholders, Buffett described what really interests him about a company's earnings. He called it owner earnings: the money an owner could take out every year without the business shrinking.
The idea is already in free cash flow, with one important difference: Buffett only subtracts the investment needed to maintain the business – not the investment that makes it grow.
The formula
- Depreciation
- costs without a cash outflow in the year, which are added back
- Maintenance capex
- investment needed to keep the business at its current level
Buffett named the catch himself: how much of it is maintenance and how much is growth is not in any annual report. It is an estimate. A rough guide is depreciation, because it roughly reflects how fast assets wear out.
The worked example
A made-up company earns €8 per share and depreciates €3. It invests €5 in total: €2 to maintain the business and €3 for new locations.
| Item | Free cash flow | Owner earnings |
|---|---|---|
| Net income | €8.00 | €8.00 |
| + Depreciation | €3.00 | €3.00 |
| − Maintenance investment | €2.00 | €2.00 |
| − Growth investment | €3.00 | – |
| Result | €6.00 | €9.00 |
Free cash flow shows €6, because it subtracts every investment. Owner earnings show €9, because the €3 for new locations is not a cost of the running business but a decision for the future. For a growing company, free cash flow therefore often understates what the business already earns today.
The moat
High profits attract competitors. Whoever earns well gets competition, and that pushes down prices and margins – unless the company has something others cannot simply rebuild. Buffett calls this the moat: just as a moat protects a castle, this advantage protects the profits.
A moat usually comes from one of these sources:
Spotting a moat in the numbers
Whether a moat is really there shows over the years. A company with a real lead earns persistently high returns on the capital it employs and keeps its margins stable, even in weaker years. If margins and returns fall bit by bit while the business grows, the moat is probably narrowing.
This matters for valuation because a wide moat justifies longer growth. In a DCF that means: you can assume with more confidence that the profits will still be there in ten years.
Three common mistakes
See the moat over many years.
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Frequently asked questions
Where do I find owner earnings?
Nowhere directly. Net income and depreciation are in the annual report, maintenance you have to estimate. Some companies voluntarily disclose their maintenance investment, which helps a lot.
How do I recognise a wide moat?
By persistently high returns on capital employed and stable margins over many years, even in crises. A single strong year is not enough.
Do only large companies have a moat?
No. Smaller companies can also have a strong advantage in a niche, for example through specialist knowledge or high switching costs for their customers.
Does a moat replace valuation?
No. Even a great company can be too expensive. The moat tells you how safe the profits are – the margin of safety tells you whether the price is right.
Not investment advice. All content is for informational and educational purposes only. The company in the example is made up.