Every quarter, companies report earnings per share (EPS) — and every quarter, financial media obsesses over whether they beat or missed "the number." Warren Buffett largely ignores this ritual. Instead, he focuses on a metric that is far harder to manipulate and far more directly tied to shareholder value: free cash flow.
"What we want is to figure out what cash a business generates over time... I call it 'owner earnings.'" — Warren Buffett, 1986 Shareholder Letter
Free cash flow (FCF) is the cash a business generates from its operations after paying for the investments required to maintain and grow its asset base. The formula is straightforward:
Operating cash flow is found on the cash flow statement, in the section labelled "Cash flows from operating activities." It adjusts net income for non-cash items (depreciation, amortisation, stock-based compensation) and changes in working capital. It reflects the actual cash moving in and out of the business from its core operations.
Capital expenditures (CapEx) are the investments the company makes in physical assets — factories, equipment, technology infrastructure, vehicles — to sustain and expand operations. These are found in the "Cash flows from investing activities" section, typically labelled "Purchases of property, plant, and equipment."
The difference — free cash flow — is the money left over after these obligations, which the company can use entirely at management's discretion: pay dividends, buy back shares, pay down debt, make acquisitions, or reinvest for growth.
Generally Accepted Accounting Principles (GAAP) require companies to follow specific rules that often disconnect reported profit from actual cash generation. Several common examples:
When a company buys equipment for $10 million, it does not record a $10 million expense in year one. Instead, it "depreciates" the cost over the equipment's useful life — say, $1 million per year for 10 years. Net income in year one reflects only the $1 million depreciation charge, even though the company paid out $10 million in cash. Free cash flow captures the actual cash payment immediately.
A company can record a sale as revenue in the current quarter even if the customer has not paid yet. That revenue flows into net income, but the cash hasn't arrived. Free cash flow only counts cash actually received.
Companies sometimes capitalise costs that might reasonably be expensed — spreading them over several years rather than recognising them immediately. This improves reported earnings but does not change the underlying cash reality.
None of these accounting differences make earnings "dishonest" — they follow rules designed for other purposes. But for an investor trying to understand what a business is actually generating, cash flow is a more direct and more manipulation-resistant measure.
In his 1986 shareholder letter, Buffett defined what he called "owner earnings" as the closest approximation to the cash available to the business owner:
"These represent (a) reported earnings plus (b) depreciation, depletion, amortisation, and certain other non-cash charges... less (c) the average annual amount of capitalised expenditures for plant and equipment that the business requires to fully maintain its long-term competitive position and its unit volume."
The key phrase is "fully maintain." Buffett is careful to subtract only the maintenance CapEx — the spending required just to keep the business running at its current level. Any excess CapEx for growth is optional, not a constraint on available cash. This distinction is subtle but important: a business that spends heavily on growth is not generating less "owner earnings" as long as that spending produces a return.
Total capital expenditure reported in financial statements combines two very different types of spending:
Spending to expand capacity, enter new markets, or build new infrastructure. Creates future earning power. Can be stopped without damaging the existing business.
Spending to keep existing assets functional. Cannot be avoided without the business deteriorating. Must be subtracted to get true owner earnings.
Companies do not separately disclose maintenance vs. growth CapEx in their financial statements. Analysts typically estimate maintenance CapEx as a percentage of revenue, or use depreciation as a proxy. For most asset-light businesses — software companies, financial firms, consumer brands — maintenance CapEx is very low, and reported FCF is a good approximation of owner earnings.
Free cash flow yield relates FCF to the company's market capitalisation:
This is the cash-based equivalent of earnings yield (the inverse of P/E). It answers a simple question: for every dollar I invest in this stock today, how much cash does the business generate for me annually?
Buffett has described using FCF yield as a comparative benchmark — comparing it to the risk-free rate (the 10-year Treasury yield). A stock yielding significantly more than Treasuries in free cash flow, with growing underlying operations, is offering a premium that compensates for the additional risk of equity ownership.
The businesses Buffett has held longest — Coca-Cola, American Express, Apple, See's Candies (private) — share a common characteristic: they generate very large amounts of free cash flow relative to their asset base and their earnings. This is the hallmark of a great business: it does not need to constantly reinvest large amounts of capital to maintain its earnings power.
A business that reports $1 billion in net income but requires $900 million in annual CapEx just to maintain operations generates only $100 million in true owner earnings. A business that reports $500 million in net income but requires only $50 million in CapEx generates $450 million. Despite reporting lower earnings, the second business is generating far more value for its owners.
A sustained gap between reported earnings and free cash flow is one of the most important warning signs in financial analysis. If a company consistently reports strong earnings but generates weak or negative FCF, it means earnings are not translating into cash — and cash is what matters.
Common causes of this divergence that warrant investigation:
Free cash flow is central to two parts of our analysis. First, it is one of the six criteria in the Buffett Score: we evaluate whether a company's FCF is positive, growing, and substantial relative to its market value. Second, it is the starting point for the intrinsic value DCF calculation — the entire model is built on projecting future FCF and discounting it to present value.
Companies that fail the FCF criterion — even if they pass the other five — will not reach a high Buffett Score. Earnings without cash flow is not a business Buffett wants to own.
