10-K Diver Profile picture
Jun 6, 2020 26 tweets 5 min read
1/

Get a cup of coffee.

In this thread, I'm going to walk you through the concept of "owner earnings".
2/

Imagine that you'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.
3/

Then you spend $100K on swanky furniture, fancy lights and other fixtures, etc.

Now the place looks really inviting. And you don't have to touch it for the next 10 years.
4/

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.
5/

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.
6/

Fast forward 1 year.

We're now at Dec 31, 2019.

Your coffee shop was a huge success.

You sold $1M of coffee in the very first year.
7/

Let's calculate how much money you made in 2019.

Your revenues were $1M. That's how much coffee you sold.

And your expenses? They come to around $450K:
8/

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.
9/

Let's say your coffee shop has a checking account where all cash is kept.

On Jan 1 2019, let's say this checking account had enough to cover about 3 months worth of expenses. That's ($5K rent/mo + $30K supplies/mo)*3 = $105K.
10/

Here'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?
10/

No.

Why? Let'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).
11/

So, the checking account's balance will have increased by $470K (not $440K) during 2019.

So, the account's balance on Dec 31 2019 will be $575K (initial $105K plus this $470K).
12/

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.
13/

This $30K depreciation is a very real cost to you.

It just didn'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.
14/

Key lesson 1: Learn the difference between "net income" and "operating cash flow".

In 2019, your coffee shop's net income was only $440K.

But operating cash flow (the amount your checking account increased by) was $470K.
15/

Here's another question:

How much of this $470K can you actually withdraw from your coffee shop's checking account to your personal checking account, without hurting the business?
16/

Well, let's see.

As before, you want to keep 3 months worth of operating expenses in cash.

There's always inflation. In 2019, 3 months of expenses was $105K. But in 2020, it may be more like $110K.
17/

But that's not all.

In 2 years' time, you'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's no cash crunch later.
18/

Oh, and you'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.
19/

So you'll need to set aside $110K for operating expenses and $43K for future capital expenses (coffee making equipment, furniture, etc.). That's $153K.

Your coffee shop checking account has $575K.

So you can safely withdraw about $422K without hurting the business.
20/

This $422K is called "owner earnings".

It's not how much cash the business has. It's how much cash the owner of the business can safely withdraw each year *without* hurting the business's current earning power or long-term prospects.
21/

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?
22/

Owner earnings is not net income. It's not operating cash flow. It's not free cash flow.

It's an estimate based on how much cash it takes to maintain a business's earning power.

It's imprecise. But it's a concept that will help you think about businesses the right way.
23/

I'll leave you with a couple of references to learn more about owner earnings.

Buffett's 1986 letter explains the concept beautifully: berkshirehathaway.com/letters/1986.h…
24/

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.

25/

Thanks for reading! Enjoy your weekend. Stay safe. Think like an owner. 😀

/End

• • •

Missing some Tweet in this thread? You can try to force a refresh
 

Keep Current with 10-K Diver

10-K Diver Profile picture

Stay in touch and get notified when new unrolls are available from this author!

Read all threads

This Thread may be Removed Anytime!

PDF

Twitter may remove this content at anytime! Save it as PDF for later use!

Try unrolling a thread yourself!

how to unroll video
  1. Follow @ThreadReaderApp to mention us!

  2. From a Twitter thread mention us with a keyword "unroll"
@threadreaderapp unroll

Practice here first or read more on our help page!

More from @10kdiver

Feb 6
My friend @Gautam__Baid (and author of the excellent book, The Joys of Compounding) is launching a new Chapter.

It's called "Qualitative Investing And Fund Management".

Through this, Gautam wants to educate folks about important investing concepts.

A short thread: 👇👇👇
So, what's a "Chapter"?

It's a 4-week online course.

Once you enroll, you're given a curated set of resources that'll help you learn the basics of a subject over 4 weeks.

These resources are usually available for free online -- articles, blog posts, YouTube videos, etc.
Plus, you get access to an instructor (here, Gautam Baid). He shares his insights with you, you get to ask him questions, etc. -- through an online forum.

And you can also use this forum to interact with fellow course takers.
Read 9 tweets
Feb 5
1/

Get a cup of coffee.

In this thread, I'll show you how to read and understand a company's Balance Sheet.

As investors, we should be able to judge businesses by looking at their financial statements.

And the Balance Sheet, of course, is 1 of 3 key financial statements:
2/

Imagine that Alice and Bob are neighbors.

Alice owns and operates a "candles" business.

She makes candles in her loft, which she's converted into a lab of sorts.

She then takes the candles to a local home goods store, which sells them and pays her at the end of each month.
3/

Suppose it costs Alice $10 to make a candle. This is the cost of the candle's glass case, wax, wick, etc.

And suppose the home goods store pays Alice $15/candle, and sells 1460 of her candles every month.

Then, Alice would make ~$87.6K/year. Here's her Income Statement:
Read 28 tweets
Feb 5
1/

What can horse racing teach us about value investing?

This was the topic we discussed in our latest Money Concepts episode.

Here's the full ~1.5 hour recording. If that seems too long, scroll down for some key insights and short highlights!

Link: callin.com/link/iOmfhLZitI
2/

Steven Crist is highly skilled at betting onvv and profiting from horse races.

He's written a book chapter -- Crist On Value. It's 13 pages long.

Prof. Michael Mauboussin (@mjmauboussin), whom I greatly admire, has called this "the best 13 pages on value investing".
3/

You can get this book chapter (for free, as a PDF) here:

Link: hvst.com/posts/value-an…
Read 19 tweets
Jan 25
Folks, here's our latest Money Concepts episode.

It's about the "magic of retained earnings" -- how businesses can create tremendous value by retaining part of their earnings and compounding it over time.

Scroll down for some ~2 minute highlights!

callin.com/link/KuNDjEYcDF
Highlight #1

The "Intrinsic Value" of a stock is the discounted present value of ALL future dividends from that stock.

And businesses that retain part of their earnings and compound it at a decent rate can deliver *exponential* growth in this intrinsic value over time.
Highlight #2

All companies eventually die.

IF a company NEVER pays a dividend from the time it is founded until its eventual death, then the Intrinsic Value of that company's shares is ZERO.

Even if the company produces growing earnings and cash flows for a period of time.
Read 7 tweets
Jan 22
1/

Get a cup of coffee.

In this thread, I'll walk you through the "magic of retained earnings".

This is the basic theory behind why stocks grow exponentially over long periods of time.

As investors, we'd do well to understand this theory -- and the assumptions it's based on.
2/

Warren Buffett's 2019 letter to Berkshire shareholders has a section titled "The Power of Retained Earnings".

In this section, Buffett describes how businesses can deliver enormous benefits to their owners by *retaining* and *compounding* a portion of their earnings:
3/

Let's break down this key insight from Buffett's letter.

Imagine we have a business that earns $100M per year.

Let's say this $100M neither grows nor shrinks over time.
Read 32 tweets
Jan 22
Folks, here's our latest Money Concepts episode.

We met on Sunday. We discussed several concepts related to compounding and exponential growth -- for ~1.5 hours.

If that seems too long, scroll down for some ~2 minute highlights!

callin.com/link/MHIxpuMaIc
Highlight #1

Compounding means *exponential* growth of wealth.

Examples of compounding: (1) A savings account that accrues interest, (2) a business that retains earnings and re-invests them to earn steady returns.

NOT an example of compounding: hourly wages.
Highlight #2

Buffett's early start is a big part of his > $100B net worth. He bought his first stock when he was just 11.

Thankfully, most of us don't need $100B to be happy in life. If our goal is simply to achieve Financial Independence, we can afford to start a little later.
Read 10 tweets

Did Thread Reader help you today?

Support us! We are indie developers!


This site is made by just two indie developers on a laptop doing marketing, support and development! Read more about the story.

Become a Premium Member ($3/month or $30/year) and get exclusive features!

Become Premium

Don't want to be a Premium member but still want to support us?

Make a small donation by buying us coffee ($5) or help with server cost ($10)

Donate via Paypal

Or Donate anonymously using crypto!

Ethereum

0xfe58350B80634f60Fa6Dc149a72b4DFbc17D341E copy

Bitcoin

3ATGMxNzCUFzxpMCHL5sWSt4DVtS8UqXpi copy

Thank you for your support!

Follow Us on Twitter!

:(