If you note the bolded section of Buffett’s owner earnings, he clearly states that changes in working capital should also be in (c). That is, if a company is required to increase working capital in order to maintain its position and operations, that’s really an increase of maintenance capex.

Also, since I haven’t found a single person who can accurately judge or calculate maintenance capex, I just use the total capex in the stock value calculators which will more than cover the working capital required for maintenance.

Purpose of Free Cash Flow

The way I see it, modern corporate finance has had a lot of influence on the FCF definitions. The part that I feel most people confuse is that by including changes in working capital, it is actually calculating the amount of cash left over for shareholders at the end of the year period.

But as an investor, what exactly are you trying to measure? The amount of money that is available in the business? Or the true profitability?

That’s the key that most investors forget. We use FCF in a discounted cash flow valuation, not to measure how much money is left over for us, but to find the true profitability of the company and the rate of growth at which it can increase those profits.

This is exactly why I believe Buffett calls his modified FCF formula as owner earnings. The true earnings of a company. He publicized the formula to combat the non-effective and rather misleading EBITDA definition of profitability and cash flow.

The Buffett style of investing I’ve read in countless books all mention one thing – he looks for great ongoing businesses with competitive advantages, not how much a company can give out at the end of the year.

Working Capital Disadvantage

Working capital also has it own set of disadvantages.

Current assets and liabilities are fairly easy to manipulate and depending on the accounting method, the amount will vary by considerable amounts. E.g. a company using the LIFO method will have a much lower inventory value compared to a company that uses the FIFO method to value inventory. The two companies could have exactly the same set of products in their warehouses, but just depending on whether they use a conservative or aggressive accounting, it will make a big differences.

Working capital can also vary drastically year to year which could provide an inaccurate picture of the business as well as affect the projected growth rate.

But there is no right or wrong. It just depends on how you view a business and investment.

Summary

To sum things up, I simply exclude changes in working capital because my point of view is that I am looking for the true profitability of the company which is why I stick with Buffett’s owner earnings.