JoePonziosFWallStreet

OwnerEarningsvs.FreeCashFlow

Managers thinking aboutaccounting issues should neverforget one of Abraham Lincolnsfavorite riddles: How many legsdoesadoghaveifyoucallhistailaleg?Theanswer:Four,becausecallingatailalegdoesnotmakeitaleg.WarrenBuffett

In his 1986 Letter to Berkshire Hathaway shareholders, WarrenBuffett laidoutadefinitionandequationforownerearningsanumberthathesaid istherelevant itemforvaluationpurposesboth for investors in buying stocks and for managers in buyingentirebusinesses.

Whatisownerearnings?Beforewegetintoafullexplanation,letslayforthBuffettsformula,aswrittenintheaforementionedletter:

[Owner earnings] represent (a) reported earnings plus (b)depreciation, depletion, amortization, and certain other noncashcharges...less (c) the average annual amount of capitalizedexpenditures for plant and equipment, etc. that the businessrequirestofullymaintainitslongtermcompetitivepositionanditsunitvolume.

Itsamouthful;hence,theneedforthediscussioncontainedherein.

Ofcourse, investorsasagrouptendtohaveaneedforimmediategratificationandtendtoseekoutasingle,simple,quickformulaforinvesting.Becauseof thoseneeds, free cash flowwasbornas thearmchairinvestorsownerearnings.

Thoughattimesfreecashflowandownerearningsaresubstantiallythesame,therearetimesthattheydiffergreatlywhichcanhaveaverysignificantimpactonaninvestorsestimationofintrinsicvalue.

This report will outline the major differences between ownerearningsandfreecashflow. Itassumesthatthereaderhas,atthevery least, a rudimentary understanding of financial terms andfinancialstatements.

For additional information and more examples, visit Joe Ponzioswww.FWallStreet.com.

Page 1 of 20

TheStartUpXWidgetIncorporated

Forthisdiscussionoffreecashflowversusownerearnings,wellstartbyanalyzingafictionalcompany:XWidget Incorporated. Indoingso, thereadershouldendupwithastronggraspofhowthe incomestatement,balancesheet,andstatementofcashflowsaretiedtogethertogiveaclearpictureof thefinancialhealthandperformanceofabusiness.

XWidgetInc.isastartupcompanyinthebusinessofsellingwidgets.TostartXWidgetInc.,theownerBobdecidestobearthecostsofincorporatingsothatXWidgetstartswithacleanslate.Hisattorneycreates10,000 sharesof stock andgivesBob1,000 shares, eachwith apar valueof $1.00.Bob theninvests$50,000.Thus,beforeanysalesandbeforeanyotherbusinessisconducted,XWidgetsincomestatementiszeronoincomeorexpensesanditsday1(inthiscase,January1)balancesheetisasfollows:

January 1, 2006 Assets Current Assets: Cash & Cash Equivalents $ 50,000 Accounts Receivable Inventory Total Current Assets 50,000Total Assets 50,000

Liabilities & Stockholders Equity Current Liabilities: Accounts Payable Accrued Expenses Total Current Liabilities

Stockholders Equity: Common Stock, 10,000 shares authorized, 1,000 issued and outstanding 1,000 Additional Paid-In Capital 49,000 Total Stockholders Equity 50,000Total Liabilities & Stockholders Equity $ 50,000

Following this balance sheet is pretty straightforward. Bob put $50,000 into his business checkingaccount; hence, $50,000 in Cash & Cash Equivalents. It wasnt a loan to the company; rather, Bobinvested inhiscompany.His1,000sharesofstockhaveaparvalueof$1.00pershareor,$1,000.Whenheinvested$50,000intohiscompany,$1,000ofthatwenttocoverthe$1,000parvalueofstockandtherestwent inasAdditionalPaidInCapitalmoneyBob investedaboveandbeyondtheparvalueofthestock.

Page 2 of 20

In this simple startup example, the balance sheet tells just about thewhole story to this point. In amorecomplexexample,investorswoulddefinitelywanttoseeastatementofcashflows.Letslookatthecashflowsforthisperiod,andthengetintobusiness:

For the period endedJanuary 1, 2006

Cash flows from operating activities: Net Income $ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Changes in operating assets and liabilities: Accounts receivable Inventory Accounts payable Accrued expenses Net cash provided by operating activities

Cash flows from investing activities: Purchases of property and equipment Net cash flows from investing activities

Cash flows from financing activities: Proceeds from issuance of treasury stock 1,000 Changes in additional paid-in capital 49,000Net cash flows from financing activities $ 50,000

Cash & Cash equivalents, beginning Cash & Cash equivalents, ending $ 50,000

Asyoucanseefromthisstatementofcashflows,nothingwasgeneratedfromthe incomestatement(thenetincome)andyousawthattherewerenochangesininventories,accountspayable/receivable,etc.Thatis,therewasabsolutelynocashflowfromoperatingactivitiesbecausethebusinessdidnotstartoperating.Nopropertyorequipmentwaspurchased;so,therewasnocashflowfrominvestingactivities.Thebalancesheetshowed$50,000ofcash$50,000morethanithadbeforeBobinvested.Hisinvestmentisreflectedinthecashflowsfromfinancingactivities.

TheFirstSale(andQuarter)NowthatXWidgetInc.hasbeenfunded,itisreadytohitthegroundrunning.Bobbuysawidgetstamp the$20,000machinehedesperatelyneeds to startmakingwidgets.He spends$1,000onbusinesscards,brochures,andothermarketingmaterials. Inaddition,hisnewbusinessphone isgoing to costhim$50amonth.

Readytomakehisfirstmillions,Bobhiresacommissiononlysalesreptopoundthestreetsanddrumup business. Bob estimates that the cost of manufacturing a widget is $5,000. If he sells them for$10,000andgivesthesalesrepa25%commission($2,500),Bobwillturnanoperatingprofitof25%,or

Page 3 of 20

$2,500 for each widget sold ($10,000minus $2,500 in commissionsminus $5,000 cost to produce =$2,500).

Bytheway:Tokeepthingssimple,Bobwillbeoperatingoutofhisgarageandwontbepayinganyrentortakinganyhomewriteoffs.

OnFebruary15,2006,thesalesrepbringsinanorderforfivewidgetsatotalorderof$50,000.Bobrecordsthesaleinhisaccountingsoftwareandgetstomakingtheproduct.Ittakessixweekstomakethewidgets,includingdelivery,andthecustomerhasthirtydaystopayuponacceptance.Assumingthecustomerholdspaymentuntilthelastpossiblemoment,Bobshouldcollectacheckfor$50,000aroundtheendofApril.

ThefirstquartercomestoacloseonMarch31,2006,andBobprepareshisfinancialstatements:

January 1, 2006 to March 31, 2006

Income Statement Gross Revenues $ 50,000 Cost of goods sold (25,000)Gross Operating Profit 25,000

Expenses Marketing (1,000) Telephone (150) Commissions (12,500) Depreciation (500)Total Expenses (14,150)

Earnings, before taxes 10,850 Provision for taxes (1,628)Net Income $ 9,222

Net Income per Share $ 9.22

Notmanybusinessesturnaprofittheirveryfirstquarter.Bytraditionalmeasures(particularlythoseonWallStreet),Bobsbusinessisdoingextremelywell.Wenowturntocheckouthisbalancesheet:

[nextpage]

Page 4 of 20

March 31, 2006 Assets Current Assets: Cash & Cash Equivalents $ 272 Accounts Receivable 50,000 Inventory Total Current Assets 50,272 Plant, Property, & Equipment, net 19,500Total Assets 69,772

Liabilities & Stockholders Equity Current Liabilities: Accounts Payable 50 Accrued Expenses 10,500 Total Current Liabilities 10,550

Stockholders Equity: Common Stock, 10,000 shares authorized, 1,000 issued and outstanding 1,000 Additional Paid-In Capital 49,000 Retained Earnings 9,222 Total Stockholders Equity 59,222Total Liabilities & Stockholders Equity $ 69,772

Thingsseemtobeinorder.Shareholderequityisup$9,222or18%fromwhenXWidgetstartedjustthreemonths earlier.We see the $50,000 order under Accounts Receivable. That is the sale that isoutstandingwiththecustomer.XWidgetjustmadedeliveryoftheproductyesterdayandthecustomerhasthirtydaystopaythe$50,000.

Weseecashofjust$272.Wellgettothatinthestatementofcashflows.

Thecompanyhassomephysicalassetsintheformofa$20,000widgetstamp.Inthiscase,XWidgetInc.isdepreciatingitovertenyears,attherateof$2,000ayear,or$500aquarter.So,Plant,Property,&Equipment(PPE)showsthe$20,000widgetstampminus$500indepreciationfortheperiod.

AccountsPayable is$50.Thephonebill is$50amonth.AsofMarch31,2006,XWidgethadreceivedthree$50phonebills fora totalphoneexpenseof$150.Wesawthaton the incomestatement.Thephonebillisdueonthetenthdayofthemonthfollowingtheendofthebillingcycle;so,XWidgetInc.hasreceivedthreebills,buthasonlypaidtwoofthem.Themostrecentbill(for$50)forthemonthofMarchisdueonApril10th.Thus,thecompanyhasanAccountsPayablebalanceof$50.

XWidgetInc.rackedup$10,500inAccruedExpenses.Wellgettothatinthestatementofcashflows.

Finally,thecompanyhad$9,222ofnetincome,whichtranslatesinto$9,222ofRetainedEarningsunderShareholderEquity.

Page 5 of 20

If,atthispoint,youarethinkingaboutthe$10,500ofAccruedExpensesortheanemic$272ofcashinthebank,youarestartingtoseetheabsurdityoflookingsolelyattheincomestatement.Letsmoveontothecompanysstatementofcashflows:

January 1, 2006 to March 31, 2006

Cash flows from operating activities: Net Income $ 9,222 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 500 Changes in operating assets and liabilities: Accounts receivable (50,000) Inventory Accounts payable 50 Accrued expenses 10,500Net cash provided by operating activities (29,728)

Cash flows from investing activities: Purchases of property and equipment (20,000)Net cash flows from investing activities (20,000)

Cash flows from financing activities: Proceeds from issuance of treasury stock 1,000 Changes in additional paid-in capital 49,000Net cash flows from financing activities $ 50,000

Cash & Cash equivalents, beginning Cash & Cash equivalents, ending $ 272

Forillustrativepurposes,wellbeginfromthebottomandworkbackwards.Weknowthatthecompanyhadabsolutelynocashatthebeginningofthequarter(justbeforeBobinvestedhis$50,000).Lookingatthebalance sheet,wealsoknow that the companyhas just$272 in thebank. That takes careof thebeginningandendinglinesofCash&Cashequivalents.

Movinguptofinancingactivities:Bobinvested$50,000intohiscompanyonJanuary1,2006.Wewentthroughthatbefore.SufficeittosaythatBobdidnotinvestorwithdrawanymoneyduringthisquarter.

Movinguptoinvestingactivities:Bobspent$20,000onawidgetstamptheequipmentheneedstomakethewidgetsthathissalesrepwillsell.Thewidgetstamprequiredacashoutlayof$20,000;thus,thisfigureisnegative.XWidgetInc.didnothaveanyotherinvestingactivity.

Finally,wemoveuptooperatingactivities:Weneedtoreconcilethe$9,222ofnetincomeXWidgetreportedon its incomestatementtotheactualcashconsumedorgeneratedbytheoperationsofthebusiness.Inthiscase,westartwiththe$9,222ofnetincome,becausethatwasthereportedamount.Now, we add and subtract operating items that required or generated cash that was not otherwisereflectedintheincomestatement.

Page 6 of 20

First, depreciation of $500. Rather than taking a $20,000 deduction on the companys incomestatement,Bob isabletowriteoffapieceof thewidgetstampforeachof thenexttenyears. Inthiscase, Bob iswriting $500 off his tax return each quarter for the next forty quarters. Although it is aperfectly legalwriteoff, thedepreciationdoesnotrequireacashoutlay; so,weaddthedepreciationbackintothe$9,222aswereconcilenetincometonetcashfromoperations.

Next, Accounts Receivable of $50,000. XWidget Inc. recorded $50,000 of revenue, but has not yetcollectedthatrevenue;so,itisachargethataffectednetincomefromoperations,butdidnotactuallyprovide (or require) cash fromoperations. So,we have to backout the $50,000 fromnet incomebyshowinganegativenumberfortheincreaseinAccountsReceivable.

Inventory.Bobhasnotmanufacturedanyinventorythathasyettobesold;so,thisisunchanged.

AccountsPayable.XWidget Inc.showeda$150expenseforthephonebill,but itonlypaidout$100.(See the Accounts Payable discussion above.) The companywrote off $150, but only used $100 ofcash;so,AccountsPayableincreasedby$50andweneedtoaddthatincreaseintofurtherreconcilenetincometonetcashfromoperations.

Finally,AccruedExpenses.Hereswhereitgetshairy.RecallthatBobofferedhissalesassociatea25%commission for selling widgets.With a $50,000 order in hand, the sales associate earned a $12,500commission.Afterspending$20,000onthewidgetstamp,spendinganother$25,000ontheproductsneededtomanufacturethewidgets,havingpaid$100ofphonebills,havingspent$1,000onmarketingmaterials,andhavingwrittenUncleSamacheckfor$1,628intaxes,Bobdidnothaveenoughcashleftto pay the full commission. Bob had spent $47,728 of the $50,000 in the bank leaving himwith just$2,272;so,hegavehissalesassociate$2,000upfrontandpromisedhimtheother$10,500whenthecustomerpaidinfull.

So, XWidget has to carry a $10,500 Accrued Expense $12,500 in commission deducted from netincomeminus$2,000ofcashthatwaspaidtothesalesassociate.Thatis,$12,500affectednetincome,butonly$2,000affectedcash,leavingabalanceof$10,500.

Andthatshowthisprofitablebusinesswentfrom$50,000inthebanktojust$272.

Bobvs.TheGovernmentGAAPEarningsvs.FreeCashFlowvs.OwnerEarnings

AsfarasUncleSamisconcerned,Bobsbusinessisthriving.With$10,850ofpretaxearnings,UncleSamwantshis$1,628pieceofthepie.WallStreetwouldalsorejoiceinBobssuccess.Withamodestpricetoearningsratioof10,Bobsstockwouldbetradingat$92.22($9.22persharex10).Hedbeabletosellhisbusinessinthestockmarketfor$92,220his1,000sharestimes$92.22ashare.

Andperhapsheshould.

Page 7 of 20

Lets takea lookatXWidget fromBobsperspectiveanownersperspectivebycalculatingownerearningsandfreecashflow.

Freecashflowissimplycalculatedas:

Netcashprovidedbyoperatingactivities + Purchasesofpropertyandequipment(CapitalExpenditures,rememberthisisnegative)

InthecaseofXWidget,thiswouldcomeoutto:

$(29,728) Netcashprovidedbyoperatingactivities + $(20,000) Purchasesofpropertyandequipment $(49,728) FreeCashFlow

Inthiscase,weseethatthebusinessoperationsafterspendingthemoneytobuythewidgetstamp,without which there would be no operations required $49,728 in cash. Now, lets get ownersearnings:

ReportedEarnings + Depreciation,Depletion,andAmortization + CertainOtherNonCashCharges(thatis,changesinworkingcapital) + AverageAnnualCapitalExpenditures(whenexpressedasanegativenumber)

Wellgolinebyline:

$ 9,222 NetIncome + $ 500 Depreciation + $ (50,000) AccountsReceivable + $ 50 AccountsPayable + $ 10,500 AccruedExpenses + $ (913) AverageAnnual(inthiscase,Quarterly)CapitalExpenditures $ (30,641) OwnerEarnings

If you are thinking, Everything makes sense until the $ (913) of capital expenditures. You lost methere,dontworry.Heresthefirstdiscrepancybetweenfreecashflowandownerearnings:

Free cash flow generally assumes that all capital expenditures are average annual capitalexpenditures. Though it is entirely possible that XWidget Inc. would have to spend $20,000 eachquartertomaintain itsunitoutput, itstotally impracticaland improbable. If thewidgetstampisonlygoodforfivewidgets,andthenithastobereplacedfor$20,000,XWidgetcouldnotpossiblysellthemforjust$10,000apiece.

Ownerearningsrequiresabitmoreinsightandthought.Inthiscase,XWidgetexpectstorunthewidgetstampfortenyears,afterwhichitwillsellitforscrapforabout$2,000.Inthefirstyear,itwontrequireany maintenance; in the second year, Bob will have to invest $500 for regular maintenance of the

Page 8 of 20

$3,000.

widgetstamp.Asthemachineages,Bobwillhavetospendmoreandmoretokeepitrunning,until itmakessensetoscrapthemachineandbuyanewone.

Totofullymaintainitslongtermcompetitivepositionanditsunitvolume,XWidgetwillreplacethemachine every ten years, and will invest a total of $19,500 over those ten years to keep it runningsmoothtomaintainitsunitvolume.

So,XWidgetscapitalexpendituresforthenexttenyearswouldlooklikethis:

Year1: $ (20,000) Buythewidgetstamp Year2: $ (500) Regularmaintenance Year3: $ (1,000) Regularmaintenance Year4: $ (1,500) Regularmaintenance Year5: $ (2,000) Regularmaintenance Year6: $ (2,500) Regularmaintenance Year7: $ (3,000) Regularmaintenance Year8: $ (3,000) Regularmaintenance Year9: $ (3,000) Regularmaintenance Year10: $ (3,000) Regularmaintenance Year10: $ 3,000 Saleofwidgetstampatendofyear10 Total: $ (36,500) TotalCapitalExpendituresovertenyears Annual: $ (3,650) AverageAnnualCapitalExpenditures Quarterly: $ (912.50) AverageQuarterlyCapitalExpenditures

AfterYear10,XWidgetwouldshelloutanother$20,000orthegoingrateat thattime foranewwidgetstampandstartthecycleagain.

Andso, lookingatthreedifferentmeasures,weseethreeverydifferentstories.GAAPearningstellusBobsbusinessisveryprofitableandthatBobismakingmoneyhandoverfist.Wecertainlyknowthatsnot the case because Bob shelled out $50,000 and still cant afford to pay his sales associate acommission(norcanhepayhimselfadime!)

Lookingat FreeCashFlow,we seeabusiness that isoperatingat a$49,728deficit. Though thatwasabsolutely the case for the first quarter, we shouldnt expect that to be the case going forward,assumingitsbusinessasusual.Bobwillnotneedtospend$20,000aquarteroncapitalexpenditures.

WithOwnerEarnings,weseeabusinessthatrequired$30,641ofcashforitsoperationsinthisquarter.WhileFreeCashFlowgivesamoreaccurateportrayalof theparticularquartersperformance,OwnerEarningstakesastepbackandlooksatthebusinessasanongoingconcernovermanyyears.

Atthispoint,youmaybethinking,Well,Iliketoplayitsafe;so,IthinkFreeCashFlowisbetter.Letslookatafewmorequartersbeforeyoujumptoanyconclusions.Laterinthisdiscussion,welltalkaboutafewothercaveatsofFreeCashFlowthatcanmakeitasomewhatlessattractivethanownerearningsparticularlywhenthereismoretothecashflowstatementthaninthefollowing,simplifiedexample.

Page 9 of 20

XWidgetPerformanceThreeYearsofFinancialPerformance

IncomeStatement,forthefiscalyearsendedDecember31,

2008 2007 2006 Gross Revenues $ 340,000 $ 260,000 $ 170,000 Cost of goods sold (163,200) (128,700) (85,000) Gross Operating Profit 176,800 131,300 85,000 Gross Margin 52% 51% 50% Expenses Marketing (4,000) (3,200) (1,800) Telephone (600) (600) (600) Commission (85,000) (65,000) (42,500) Depreciation (2,150) (2,050) (2,000) Salaries (76,000) (58,000) (36,000) Total Expenses (167,750) (128,850) (82,900)

Earnings, before taxes 9,050 2,450 2,100 Provision for taxes (1,358) (368) (315) Net Income $ 7,693 $ 2,083 $ 1,785

Earnings Per Share $ 7.69 $ 2.08 $ 1.79Ataquickglance,youcanseethatXWidgethasbeenincreasingitsgrossmargin.Itscostinglessandlesstomakemoreandmorewidgets.Thiscouldbea functionof lowermaterialcosts;or, itcouldbethatXWidget isgettingbetterpricingbecauseofthevolumeofbusiness it isdoingwith itssuppliers.(Youdhavetochecktheannualreportstofindout.)

The companyhasbeen increasing itsmarketingeffortswhich canbeagood thing if themarketing iseffective. Depreciation has been creeping up a result of the ongoing regular maintenanceexpenditureslaidoutpreviously.

Bobbegantakingasalaryin2006,andhasbeenincreasingthatovertimefrom$36,000to$76,000.

Letsturntothebalancesheetsonthenextpage.

Page 10 of 20

XWidgetPerformanceThreeYearsofFinancialPerformanceBalanceSheet,asofDecember31,

2008 2007 2006 ASSETS Current Assets Cash & Cash Equivalents $ 1,311 $ 7,468 $ 3,835 Accounts Receivable 30,000 25,000 20,000 Inventories 15,000 5,000 10,000 Total Current Assets 46,311 37,468 33,835 PPE, net 15,300 16,450 18,000TOTAL ASSETS 61,611 53,918 51,835

LIABILITIES & STOCKHOLDERS EQUITY Current Liabilities Accounts Payable 50 50 50 Accrued Expenses Total Current Liabilities 50 50 50

Stockholders Equity Common Stock, 10,000 shares authorized, 1,000 issued and outstanding 1,000 1,000 1,000 Addl Paid-In Capital 49,000 49,000 49,000 Retained Earnings 11,561 3,868 1,785 Total Equity 61,561 53,868 51,785 TOTAL LIABILITIES & STOCKHOLDERS EQUITY 61,661 53,918 51,835

Summary:Eachyear,XWidgetshasendedtheyearwithmoresalesoutstandingthantheprioryearnotacauseforjoyorconcern;itiswhatitis.Wellseeifitsproblematicinownerearnings.Wealsoseethatthecompanybuiltaninventoryof$10,000in2006,depleteditabitin2007,andbuiltitbackupin2008.PPEshowstheongoingdepreciationofthewidgetstampasitbecomeslessandlessvaluable.

Ontheliabilitiesside,weseethatthecompanyendseachyearwith$50ofAccountsPayable.Thatisthe$50DecemberphonebillthatisdueonJanuary10thofthefollowingyear.

Finally,weseethatretainedearningshasgrownasthecompanycontinuestoshowprofitseachyear.

Letsmoveontothestatementofcashflows.

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XWidgetPerformanceThreeYearsofFinancialPerformance

StatementofCashFlows,forthefiscalyearsendedDecember31,

2008 2007 2006 Operating Activities: Net Income $ 7,693 $ 2,083 $ 1,785 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 2,150 2,050 2,000 Changes in operating assets and liabilities: Accounts Receivable (5,000) (5,000) (20,000) Inventories (10,000) 5,000 (10,000) Accounts Payable 50 Accrued Expenses Net cash provided by Operating activities: (5,157) 4,133 (26,165)

Investing Activities: Capital Expenditures (1,000) (500) (20,000) Net cash provided by Investing activities: (1,000) (500) (20,000)

Financing Activities: Proceeds from issuance of treasury stock 1,000 Changes in additional Paid-in capital 49,000 Net cash provided by Financing activities: 50,000

Cash, beginning 7,468 3,835 Cash, ending 1,311 7,468 3,835

AndnowwecanpiecetogetherthewholestoryandcomeupwithFreeCashFlowandOwnerEarnings.Inthiscase,weseethatthecompanyhad$20,000moreinAccountsReceivableattheendof2006thanithadinthebeginningoftheyear.In2007,ithad$5,000morethanattheendof2006;in2008,ithad$5,000morethanin2007.(Thisisconfirmedonthebalancesheet.)

Page 12 of 20

Wealsoseehowtheinventoriesaffectedcashtobuildthe$10,000inventoryreservein2006required$10,000ofcash.In2007,thecompanyreduceditsinventoryby$5,000thatis,itsold$5,000worthofwidgetsitdidnothavetomanufacturethatyear,resultinginadditionalcashfromthenetincome(thusthepositiveinventorychangein2007).

LetsgettotheFreeCashFlowversusOwnerEarningscalculations:

2008 2007 2006 Free Cash Flow: Cash from Operations $ (5,157) $ 4,133 $ (26,165) Capital Expenditures (1,000) (500) (20,000)Total Free Cash Flow: (6,157) 3,633 (46,165)

Owner Earnings: Net Income 7,693 2,083 1,785 Depreciation 2,150 2,050 2,000 Accounts Receivable (5,000) (5,000) (20,000) Inventories (10,000) 5,000 (10,000) Accounts Payable 50 Capital Expenditures (3,650) (3,650) (3,650)Total Owner Earnings: (8,807) 483 (29,815)

ThebigdifferencebetweenthesetwonumbersinthisverysimplifiedexampleisthatFreeCashFlowdoesnottakeintoaccountfuturecapitalspending,treatingitinsteadlikeaonetimeeventinthepast.AsBuffettexplained,[Ignoring futurecapitalexpenditures implies] that thebusinessbeingoffered isthecommercial counterpartof thePyramids forever stateoftheart,neverneeding tobe replaced,improvedorrefurbished.

Withownerearnings,youareattemptingtofigureouthowmuchcashwouldbeleftoverforownersifthebusinessbudgetedforfuturecapitalexpenditures.Somebusinessesdoplanandbudgetverywell,thus helping assure investors that capital expenditureswill remain fairly constant from year to year.Such is not the case with XWidgets. For example, in 2009 XWidgets will need to spend $1,500 tomaintainitswidgetstampmachine.Thecompanyhasjust$1,311incash.

As sales come in, Bobwill figureout how tobudget for this years spending.What about next year?What will happen in 2016 when the widget stampwill have to be entirely replaced for $20,000 (ormore)? In this example, FreeCash Flow showsa toughbusiness;Owner Earnings showsabusinessthatisheadedforcertaintroubleifitcontinuesonitspresentcourse.Come2016,Bobwillhavetoputupmorecash,thushurtinghisreturnoninvestment.Inthepublicmarkets,thisistheequivalentofyourcompanyissuingdebtorstock,therebydilutingyourownershipandhurtingyourreturnoninvestment(viareducedintrinsicvalue).

ThedifferencebetweenFreeCashFlowandOwnerEarningsextendsfarbeyondtheprojectionofcapitalexpenditures.Tobetterunderstand,letslookatamorecomplicatedexample.

Page 13 of 20

2007

2006

2005

Cash flows from operating activities

Net loss

(38,

732)

$ (1,978)

$

(10,

417)

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4,56

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313

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ncip

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$

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net

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15,7

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82

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Delphi charge

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50

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1,79

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911

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224

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59

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314

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GeneralMotorsCorporationAnalyzingTheNumbers

In the caseofGeneralMotors, the FreeCash Flowand theOwner Earnings yielddrastically differentresults.

2007 2006 2005 Free Cash Flow: Cash from Operations $ 7,731 $ (11,759) $ (16,856) Capital Expenditures (7,542) (7,902) (8,141)Total Free Cash Flow 189 (19,661) (24,997)

Owner Earnings: Net Income from continuing operations (43,297) (2,423) (10,621) Depreciation, Impairments, & Amortization 9,513 10,885 15,732 Change in other operating assets and liabilities, net of acquisitions and disposals (3,412) (8,512) 20 Capital Expenditures (7,893) (7,893) (7,893)Tentative Owner Earnings(1) (45,089) (7,943) (2,762)

(1) After the following discussion about Free Cash Flow versus Owner Earnings, see the discussion onDepreciationvs.CapitalExpendituresforafinalcalculationofGMsOwnerEarnings.

The 2007 Free Cash Flow shows that General Motors generated $189million from its operations, aturnaroundfromitsFreeCashFlowlossesof$20billionand$25billionin2006and2005,respectively.Focused solelyon FreeCash Flow, an investor analyzing thebusinessmight see the2006 lossof $20billion $5 billion better than in 2005 as a sign of improvement. When General Motors begangeneratingpositiveFreeCashFlowin2007,an investormightmistakenlybelievethatGeneralMotorshadfixeditsproblems,turnedthecorner,andwaspotentiallypoisedforgrowth.

OwnerEarningstellsadifferentstory.

StartingwithNet Income (Loss) from continuing operations (we need to see the performance of theongoingbusiness),weaddindepreciation,amortization,andimpairments.Weaddinthenetchangetoworkingcapital(lessthechangeincash,inthiscaseChangeinotheroperatingassetsandliabilities,net of acquisitions and disposals). Finally, we take into account the cash outflows for capitalexpenditures, ofwhichGeneralMotors has had$71billionover the last nine years, or about $7,893millionayear.

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OwnerEarnings showsus thatGeneralMotorsbusinessburned through$2.7billionof cash in2005.Thingsworsenedin2006asthebusinessconsumed$7.9billion.ThoughFreeCashFlowshowed2007tobethebestofthethreeyears,OwnerEarningsshowsittobetheworstofallconsumingmorethan$45billion.

Why the discrepancy? In this case, the capital expenditures had very little effect on the differencebetweenFreeCashFlowandOwnerEarnings.Instead,thedifferenceisfoundinnoncashchargesthatGMdeductedfromearnings,butthatwereaddedbackinwhenreconcilingthestatementofcashflows.FreeCashFlowblindlyassumesthatallofthoseexpensesshouldbenefitowners;OwnerEarningsseesmanyofthoseexpensesaspotentiallydilutiveand/orfuturecommitments,anddoesnotcreditowners.

LetmeexplainwithsomeexamplesfromtheGeneralMotorsstatementofcashflows.Illtouchonandexplainsomeofthecommonadjustmentsyoullseeonstatementsofcashflows:

Other postretirement employee benefit (OPEB) expense; OPEB payments: In 2007, GeneralMotorsdeducted$2,362fromitsnetincomeasanOPEBexpense,offsetbyOPEBcashpaymentsof$3,751.ThenetresultoftheOPEBexpensewasareductionincashof$1.4billion.In2005,GMtooka$5.65billionwriteoff for theOPEBexpense,butonlypaidout$4.01billion incash,nettingGMpositivecash flowfromtheOPEBexpensesof$1.24billion.

WithFreeCashFlow,the$1.4billionspentin2007isdeductedfromcashflowfromoperations;in2005,FreeCashFlowconsidersthat$1.24billionascashgeneratedbyoperations.OwnerEarningslooksatitand says, At some point, the OPEB expense and OPEB paymentwill have to cancel each other outbecauseGMcanthaveasurplusofretirementbenefitsifeveryoneretiresandcashesoutoftheplan.RegardlessofhowmuchorhowlittleGMmanagementdecidedtopayintotheOPEB,itisarealexpensethatbelongsinnetincomeandshouldnotbereconciledasanoncashcharge.Itwilleventuallyhavetobepaid;so,weleaveit innetincome.(Itssimilartoaveragingcapitalexpendituresthecompanywilleventuallyhavetospendthemoney,evenifitdoesntdosothisyear.)

Provision fordeferred taxes. The2007 statementof cash flows showsa$36.977billionprovision fordeferredtaxes.Herestheshortanswer:Eventually,UncleSamwillwanthismoney;so,toreconcilethetax expense on the net income to any deferred taxes is silly. Accordingly, based on our currentcircumstances and uncertainty regarding our future taxable income, we recorded full valuationallowances against these net deferred tax assets during the third quarter of 2007. If and when ouroperating performance improves on a sustained basis, our conclusion regarding the need for fullvaluationallowancescouldchange,resultinginthereversalofsomeorallofthevaluationallowancesinthefuture.

So, if GM returns to profitability, it will need to pay these taxes. To put it simply, GM reduced itsdeferredtaxassets(anoncurrentasset,notworkingcapital)onitsbalancesheetfrom$33.1billionto$2.1billion, andexperiencedan increase in itsdeferred tax liabilities (anoncurrent liability, alsonotworkingcapital)ofroughly$7billion.Puttingasidethetaxdance,keepinmindthatUncleSamwillwanttogetpaid.The2007taxbillof$37.2billionreducednetincome.

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FreeCashFlowaddsinthedeferredtaxesasthoughthecompanywillneverhavetopaythemasifthe$37billionoftaxesGMowestotheGovernmentisagift.AccordingtoFreeCashFlow,GMownerscouldeffectivelypullthat$37billionofcashoutofthebusiness.UncleSamwoulddefinitelyhavesomethingtosayaboutthat.

Owner Earnings does not reconcile the deferred taxes because it recognizes that GMwill eventuallyhavetopaythisexpenseoritwillbeoutofbusiness.

StockBased Compensation Expense. Though GM does not have any stockbased compensationexpenselistedonthestatementofcashflows,itisacommonitemyouwilllikelyfindonmanycashflowstatements.Whenacompanyissuesstockoptions,itgenerallyexpensesthoseoptionsfromnetincome.Stockoptionscanhelpa company reduce its tax liability,butdonot requireacashoutlay.FreeCashFlowpresumes that the cashbenefit from issuing stockoptionsbelongs toowners; so, it adds in thestockbasedcompensationexpense.OwnerEarningsdoestheoppositeitseesstockoptionsforwhattheyare(dilutivetoowners)anddoesnotreconcilethem.Instead,itleavestheexpensealonebyusingnetincomeandignoringthestockbasedcompensationexpenseonthestatementofcashflows.

TheQuestionYouMustAskWhyisthiscashhere?

When decidingwhether or not to include an item in your owner earnings calculation, youmust askyourself, Why is thiscashhere (orgone)? In thecaseofGMs2005OPEBacrobatics,GMendedupwith$1.24billionmorethanitexpensedfromnetincomethatyear.Eventually,GMwouldhavetopaythatcashout;so,itisnotcashthatbelongstoowners.

Whataboutthoseoperatingassetsandliabilities?Tobestunderstandwhyyouincludeworkingcapitalinyourequation,gobacktoBobscompanyXWidget Inc.Bob invested$50,000 inhisbusinessandshowedaGAAPprofitinhisveryfirstquarter.Still,Bobsbusinessrequiredmorethan$49,000ofcashtogetstarted.Tostayinbusiness,oneoftwothingshadtohappen:

1. Thecustomerwouldhavetopaythe$50,000(AccountsReceivable);or,2. Bobwouldhavetocomeupwithmoremoney.

Now, Bob could have reduced his tax liability by issuing stock to his employee rather than paying acommission.Would thathave increasedhis cash flow?Yesandno.On theonehand,Bobwouldnothavetoshelloutanycashintheformofcommission,therebyincreasinghiscashavailableforgrowth;on the other hand, Bob would no longer be sole owner of the company, but a partner with hisemployee. Bob would effectively dilute his ownership and be entitled to less of the value of thecompanygoingforward.

IntheAccountsReceivableexample,theanswertothequestionwouldbe:Becausethecompanyhasanoutstandingorderfor$50,000thecashishereorgonebecauseofoperations.Inthestockoptions

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example,theanswertothequestionwouldbe:BecauseBobtriedtosavecashthecashishereorgonebecauseofadecisionbymanagementtopreserve(oruseexcess)cash.

GeneralMotorsCorporationGettingtoFinalOwnerEarnings

ThereisonelaststeptocalculatingGMsOwnerEarningsastepthat isnotextremelycommon,butworthnoting(andcalculating)inthisexample.Depreciationisanoncashchargethatallowsacompanyto spread thecostofanassetover thecourseofmanyyears. The ideabehinddepreciation is that ithelpscompaniessmoothoutGAAPearnings.

Overthelongterm,thedifferencebetweentotaldepreciationandtotalcapitalexpendituresshouldbezero.Thatis,ifacompanyspends$10,000onapieceofequipmentandtheIRSallowsthecompanytodepreciatetheassetovertenyears,thecompanywilltakea$1,000depreciationexpenseineachofthetenyears.Attheendoftenyears,thecompanywillhavepaid$10,000forthecapitalexpenditureandwillhaveearnedviaataxdeduction$10,000($1,000ayeartimes10years)indepreciation.

Thisisnottosaythatyoushouldtaketheshorthandmethodofmerelycancellingoutdepreciationandcapitalexpendituresfromyourcalculations.Whiletheaboveistruewhenlookingatabusinessfromitsstartingpointuntil thepointatwhich itwindsup itsoperations, it isnotnecessarilytrue inanygivenyearorsolongasthebusinessisanongoingoperation.

Thisiswherecapitalexpendituresanddepreciationgettricky.Whenacompanyisspendingalotmoreoncapitalexpendituresthanitisrecordingasdepreciation,itisforoneoftworeasons:

1. The company must make capital expenditures that exceed depreciation merely to maintaincompetitive;and/or,

2. The business is making capital expenditures above and beyond its requisite regularmaintenance capital expenditures. (These are usually called Growth Capital Expendituresversus Maintenance Capital Expenditures thoughmost annual reports do not separate thetwoforinvestors;so,aninvestormustmakeeducatedassumptionsaboutcapitalexpenditures.SuchappearedtobethecasewhenweanalyzedWalMart:www.fwallstreet.com/blog/44.htm.)

GMhaspreciselytheoppositedepreciationandamortizationgreatlyexceedscapitalexpenditures,anobviously impossible situation since future capital expenditures have to be made to cause futuredepreciation.Thiswouldleadustooneoftwoconclusions:

1. GMisnotspendingenoughtomaintainitsplant,property,andequipment;or,2. Thisisatemporarystateofaffairsduetothepurchaseofalonglifeassets(suchasabuilding)

orbecausegoodwillorotherintangiblesarebeingamortizedoverextremelylongperiods.

In this case, we cant assume this happy state of taking bigger tax writeoffs than were normallyallowedwill continue forever. Becausewe know that, over the longterm, capital expenditures anddepreciationwillprovideanetsumofzero,andbecausewerenotworriedaboutunderstatingcapital

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expenditures (because depreciation is greater than capital expenditures), we can assume thatdepreciationandcapitalexpendituresare thesameforGeneralMotorsundernormalconditions.Anyexcess benefit it receives today by taking large depreciationwriteoffswill be offset in the future bylargercapitalexpenditures.

So,ourfinalownerearningscalculationforGMwouldbeasfollows:

2007 2006 2005 Owner Earnings: Net Income from continuing operations (43,297) (2,423) (10,621) Change in other operating assets and liabilities, net of acquisitions and disposals (3,412) (8,512) 20Final Owner Earnings (46,709) (10,935) (10,601)

In this case, GMs automotive business is even uglier than we thought. The companys operationsrequirednearly$11billionofcashin2005and2006.In2007,thebusinesswashammeredevenworse,requiringnearly$47billionofexcesscashjusttokeepthecarscomingofftheassemblyline.

Howdid it cover this shortfall? It began selling businesses, selling finance receivables, playing gameswiththepensionandOPEB,refinancingdebt,andworkingsometaxmagic.Ofcourse,asthebusinessdeteriorated,sotoodidthestockprice:

Price follows value. When the value deteriorates rapidly (as is often the case when a businessoperationsarecashhungrybeasts),thestockpriceisusuallynottoofarbehind.

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OwnerEarningsvs.FreeCashFlowPuttingItIntoPerspective

WeveseenthetroublewithrelyingsolelyonGAAPearnings.BobsbusinesswasprofitablefromaGAAP/IRS/WallStreetperspective;still,ifhisfirstcustomerdidntpay,Bobwasoutofbusiness.

Free Cash Flow is a shorthand method for scanning companies. When a company has minimalreconciliationtonetincomeandfairlysteadyandpredictablecapitalexpenditures,FreeCashFlowandOwner Earnings are substantially the same. In that case, either can be used for valuation purposes.Because of the investors margin of safety, a minor difference between Free Cash Flow and OwnerEarningswouldbeinsignificantwhencalculatingintrinsicvalue.

Owner Earnings is the best indicator of cash flow from the operating activities of the business,regardlessofhowmanagementstrivestojuggleprofitabilityandcashflow.WhenacompanyhasalargeamountofnoncashchargestoGAAPearnings,OwnerEarningsisgenerallyamorereliableindicatorofbusinessperformancethanFreeCashFlow.Infact,dependingonhowcreative,aggressive,orcautiousmanagement gets, Free Cash Flow can be extremely skewed in these cases, aswe sawwithGeneralMotors.

It is important tonote that,whileFreeCashFlowandOwnerEarningscanbesubstantially thesame,theycanalsobesubstantiallydifferent.FocusonOwnerEarnings,anduseFreeCashFlowasashorthandonlywhenitmakessense.

Questions?Comments?VisitJoePonziosFWallStreet:www.FWallStreet.com.

Bestofluckwithyourinvesting,

JoePonzio

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