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Get a cup of coffee.
In this thread, I& #39;m going to walk you through the concept of "owner earnings".
Get a cup of coffee.
In this thread, I& #39;m going to walk you through the concept of "owner earnings".
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Imagine that you& #39;re opening a coffee shop.
You find a nice corner location with lots of foot traffic. And you sign a lease. Your monthly rent, including all utilities, will be $5K.
Imagine that you& #39;re opening a coffee shop.
You find a nice corner location with lots of foot traffic. And you sign a lease. Your monthly rent, including all utilities, will be $5K.
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Then you spend $100K on swanky furniture, fancy lights and other fixtures, etc.
Now the place looks really inviting. And you don& #39;t have to touch it for the next 10 years.
Then you spend $100K on swanky furniture, fancy lights and other fixtures, etc.
Now the place looks really inviting. And you don& #39;t have to touch it for the next 10 years.
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Next, you buy some high-end coffee making equipment: coffee roasters, espresso machines, etc. This sets you back about $60K.
This equipment will last you 3 years.
Next, you buy some high-end coffee making equipment: coffee roasters, espresso machines, etc. This sets you back about $60K.
This equipment will last you 3 years.
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Then you buy supplies for $30K: coffee beans, milk, water, napkins, paper cups, etc.
These supplies will maybe last you a month before you have to replenish them.
The next day, you open for business. This happens to be Jan 1, 2019.
Then you buy supplies for $30K: coffee beans, milk, water, napkins, paper cups, etc.
These supplies will maybe last you a month before you have to replenish them.
The next day, you open for business. This happens to be Jan 1, 2019.
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Fast forward 1 year.
We& #39;re now at Dec 31, 2019.
Your coffee shop was a huge success.
You sold $1M of coffee in the very first year.
Fast forward 1 year.
We& #39;re now at Dec 31, 2019.
Your coffee shop was a huge success.
You sold $1M of coffee in the very first year.
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Let& #39;s calculate how much money you made in 2019.
Your revenues were $1M. That& #39;s how much coffee you sold.
And your expenses? They come to around $450K:
Let& #39;s calculate how much money you made in 2019.
Your revenues were $1M. That& #39;s how much coffee you sold.
And your expenses? They come to around $450K:
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So, your pre-tax income for 2019 was about $550K ($1M revenue minus $450K expenses).
Say you make a $110K immediate payment to the IRS to cover your taxes for 2019.
That leaves you with a respectable $440K in "net income" for 2019.
So, your pre-tax income for 2019 was about $550K ($1M revenue minus $450K expenses).
Say you make a $110K immediate payment to the IRS to cover your taxes for 2019.
That leaves you with a respectable $440K in "net income" for 2019.
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Let& #39;s say your coffee shop has a checking account where all cash is kept.
On Jan 1 2019, let& #39;s say this checking account had enough to cover about 3 months worth of expenses. That& #39;s ($5K rent/mo + $30K supplies/mo)*3 = $105K.
Let& #39;s say your coffee shop has a checking account where all cash is kept.
On Jan 1 2019, let& #39;s say this checking account had enough to cover about 3 months worth of expenses. That& #39;s ($5K rent/mo + $30K supplies/mo)*3 = $105K.
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Here& #39;s a simple question:
Net income for 2019 was $440K.
Does that mean the checking account will have grown to $545K (initial $105K plus $440K net income) by Dec 31 2019?
Here& #39;s a simple question:
Net income for 2019 was $440K.
Does that mean the checking account will have grown to $545K (initial $105K plus $440K net income) by Dec 31 2019?
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No.
Why? Let& #39;s think about all the deposits and withdrawals that would have affected the account in 2019.
Deposits would have totaled $1M (all the cash collected from customers).
Withdrawals would have totaled $530K (the cash used to pay for rent, supplies, and taxes).
No.
Why? Let& #39;s think about all the deposits and withdrawals that would have affected the account in 2019.
Deposits would have totaled $1M (all the cash collected from customers).
Withdrawals would have totaled $530K (the cash used to pay for rent, supplies, and taxes).
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So, the checking account& #39;s balance will have increased by $470K (not $440K) during 2019.
So, the account& #39;s balance on Dec 31 2019 will be $575K (initial $105K plus this $470K).
So, the checking account& #39;s balance will have increased by $470K (not $440K) during 2019.
So, the account& #39;s balance on Dec 31 2019 will be $575K (initial $105K plus this $470K).
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But net income was only $440K. How did the checking account grow by $470K?
The $30K difference is because net income included a $30K "non-cash" charge (depreciation).
This is to account for wear and tear on furniture, coffee making equipment, etc.
But net income was only $440K. How did the checking account grow by $470K?
The $30K difference is because net income included a $30K "non-cash" charge (depreciation).
This is to account for wear and tear on furniture, coffee making equipment, etc.
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This $30K depreciation is a very real cost to you.
It just didn& #39;t affect your checking account in 2019.
But you can be sure your checking account will be hit when you need to buy new coffee making equipment in 2 years.
This $30K depreciation is a very real cost to you.
It just didn& #39;t affect your checking account in 2019.
But you can be sure your checking account will be hit when you need to buy new coffee making equipment in 2 years.
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Key lesson 1: Learn the difference between "net income" and "operating cash flow".
In 2019, your coffee shop& #39;s net income was only $440K.
But operating cash flow (the amount your checking account increased by) was $470K.
Key lesson 1: Learn the difference between "net income" and "operating cash flow".
In 2019, your coffee shop& #39;s net income was only $440K.
But operating cash flow (the amount your checking account increased by) was $470K.
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Here& #39;s another question:
How much of this $470K can you actually withdraw from your coffee shop& #39;s checking account to your personal checking account, without hurting the business?
Here& #39;s another question:
How much of this $470K can you actually withdraw from your coffee shop& #39;s checking account to your personal checking account, without hurting the business?
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Well, let& #39;s see.
As before, you want to keep 3 months worth of operating expenses in cash.
There& #39;s always inflation. In 2019, 3 months of expenses was $105K. But in 2020, it may be more like $110K.
Well, let& #39;s see.
As before, you want to keep 3 months worth of operating expenses in cash.
There& #39;s always inflation. In 2019, 3 months of expenses was $105K. But in 2020, it may be more like $110K.
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But that& #39;s not all.
In 2 years& #39; time, you& #39;ll need new coffee making equipment. That costed $60K a year ago, but may cost $70K in 2 years.
Better sock away a third of that $70K (~$23K) right now, so there& #39;s no cash crunch later.
But that& #39;s not all.
In 2 years& #39; time, you& #39;ll need new coffee making equipment. That costed $60K a year ago, but may cost $70K in 2 years.
Better sock away a third of that $70K (~$23K) right now, so there& #39;s no cash crunch later.
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Oh, and you& #39;ll need new furniture and fittings in 9 years time.
That costed $100K a year ago. It may cost $200K in 9 years. Better put away $20K this year (and each of the next 9 years) to cover that.
Oh, and you& #39;ll need new furniture and fittings in 9 years time.
That costed $100K a year ago. It may cost $200K in 9 years. Better put away $20K this year (and each of the next 9 years) to cover that.
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So you& #39;ll need to set aside $110K for operating expenses and $43K for future capital expenses (coffee making equipment, furniture, etc.). That& #39;s $153K.
Your coffee shop checking account has $575K.
So you can safely withdraw about $422K without hurting the business.
So you& #39;ll need to set aside $110K for operating expenses and $43K for future capital expenses (coffee making equipment, furniture, etc.). That& #39;s $153K.
Your coffee shop checking account has $575K.
So you can safely withdraw about $422K without hurting the business.
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This $422K is called "owner earnings".
It& #39;s not how much cash the business has. It& #39;s how much cash the owner of the business can safely withdraw each year *without* hurting the business& #39;s current earning power or long-term prospects.
This $422K is called "owner earnings".
It& #39;s not how much cash the business has. It& #39;s how much cash the owner of the business can safely withdraw each year *without* hurting the business& #39;s current earning power or long-term prospects.
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Key lesson 2: When you buy a stock, think like an owner.
How much cash can the company distribute to you each year *without* hurting its business? And how much are you paying for those future cash flows? Do the numbers make sense?
Key lesson 2: When you buy a stock, think like an owner.
How much cash can the company distribute to you each year *without* hurting its business? And how much are you paying for those future cash flows? Do the numbers make sense?
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Owner earnings is not net income. It& #39;s not operating cash flow. It& #39;s not free cash flow.
It& #39;s an estimate based on how much cash it takes to maintain a business& #39;s earning power.
It& #39;s imprecise. But it& #39;s a concept that will help you think about businesses the right way.
Owner earnings is not net income. It& #39;s not operating cash flow. It& #39;s not free cash flow.
It& #39;s an estimate based on how much cash it takes to maintain a business& #39;s earning power.
It& #39;s imprecise. But it& #39;s a concept that will help you think about businesses the right way.
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I& #39;ll leave you with a couple of references to learn more about owner earnings.
Buffett& #39;s 1986 letter explains the concept beautifully: https://www.berkshirehathaway.com/letters/1986.html">https://www.berkshirehathaway.com/letters/1...
I& #39;ll leave you with a couple of references to learn more about owner earnings.
Buffett& #39;s 1986 letter explains the concept beautifully: https://www.berkshirehathaway.com/letters/1986.html">https://www.berkshirehathaway.com/letters/1...
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This @FocusedCompound episode on cash flow statements also has many nuggets on owner earnings.
For example, if a growing business ties up a lot of money in working capital, then that money is not really available to be distributed to owners. https://www.youtube.com/watch?v=z0sQA_EhxP0">https://www.youtube.com/watch...
This @FocusedCompound episode on cash flow statements also has many nuggets on owner earnings.
For example, if a growing business ties up a lot of money in working capital, then that money is not really available to be distributed to owners. https://www.youtube.com/watch?v=z0sQA_EhxP0">https://www.youtube.com/watch...
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Thanks for reading! Enjoy your weekend. Stay safe. Think like an owner.
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Thanks for reading! Enjoy your weekend. Stay safe. Think like an owner.
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