Content of the material
What Are Look-Through Earnings?
Look-through earnings take the current period earnings of a company (as reported in a quarterly or annual report) and add to that figure all sources of earnings expected in the long-run. Look-through earnings are not necessarily a quantity; instead, look-through earnings is based on the concept that a firm’s value is ultimately determined by how retained earnings are invested in future years by the firm to produce more earnings.
The term “look-through earnings” is attributed to Warren Buffett, who prefers this concept to overcome limitations of accounting rules in determining the intrinsic values of companies. Buffett is more interested in the long-term earnings-generation capacity of a firm and less so in the annual reported numbers in its financial statements.
Key Takeaways Warren Buffett coined the concept of look-through earnings as a way of dealing with what he perceived as accounting limitations on balance sheets.Look-through earnings consist of both monies paid out to investors and funds reinvested by a company.According to Buffett, look-through earnings are a more realistic portrayal of a firm's annual gains and therefore provide a better picture of its actual value to investors.
Scenario: John Smiths Portfolio
To illustrate this point, assume John Smith, an average investor, has a portfolio consisting of two securities: Walmart and Coca-Cola. Both of these companies pay a portion of their earnings out as dividends, but if John were only to regard the cash dividends received as income, he would ignore most of the money that was accruing to his benefit. To truly see how his investments are performing, John needs to calculate his look-through earnings. In effect, he is answering the question of how much after-tax cash he would have today if the companies were to pay out 100% of the reported profit.
Stock Position 1: Walmart
Suppose Walmart reported diluted earnings per share of $2.03, John's dividends are taxed at 15%, and he owns 5,000 shares of Walmart. His look-through earnings would be the following:
$2.03 diluted earnings x 5,000 shares = $10,150 pre-tax
$10,150 x (1 – 0.15 tax rate) = $8,627.50.
Stock Position 2: Coca-Cola
Suppose Coca-Cola reported diluted earnings per share of $1.00, and John owns 12,000 shares of the company’s common stock. His look-through earnings would be the following:
$1.00 diluted earnings x 12,000 shares = $12,000 pre-tax
$12,000 x (1 – 0.15 tax rate) = $10,200.
John's Look-Through Earnings
By calculating the total look-through earnings generated by his stock holdings, we discover that John has look-through earnings of $18,827.50 after-tax ($8,627.50 + $10,200). It would be a mistake for him only to pay attention to the $6,630 that was received as cash dividends on an after-tax basis; the other $12,197.50 that had been plowed back into the two companies was accruing to his benefit.
Overall, one can thus see that Berkshire clearly continues to trade at a sizeable discount to the broad market, and that does not even include any adjustments for its large cash position yet. We believe that the current discount for Berkshire’s shares could result in more upside potential over the coming years. If Berkshire’s real earnings multiple would rise to 20, that would equate to share price gains of 25% from the current level.
Berkshire’s current book value multiple of 1.26 is also below the historical norm, which is in line with our belief that shares have upside potential still. They looked more attractive in spring, well below $200, but they are not fully valued yet. Considering the quality of the company and the profit growth that will likely occur in 2021, Berkshire could still be a solid buy in the $220 range. Buffett’s decision to spend heavily on share repurchases during the third quarter further underlines that Berkshire’s shares are indeed a solid value around current levels.