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 famed investor Warren Buffett, who prefers this concept to overcome some 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.
- 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.
Understanding Look-Through Earnings
Warren Buffett explained his concept of look-through earnings in his booklet "An Owner's Manual," which was originally distributed to Berkshire Hathaway Inc. Class A and Class B shareholders in 1996 and updated in 1999. The booklet aimed to explain Berkshire's broad economic principles of operation. In the booklet, Buffett laid out 13 "owner-related business principles."
Buffett explains the look-through earnings concept clearly in the following passage, which appears as "Principle No. 6."
"We attempt to offset the shortcomings of conventional accounting by regularly reporting 'look-through' earnings (though, for special and nonrecurring reasons, we occasionally omit them). The look-through numbers include Berkshire's own reported operating earnings ... plus Berkshire's share of undistributed earnings of our major investees—amounts that are not included in Berkshire's figures under conventional accounting ...
...We have found over time that undistributed earnings of our investees, in aggregate, have been fully as beneficial to Berkshire as if they had been distributed to us (and therefore had been included in the earnings we officially report). This pleasant result has occurred because most of our investees are engaged in truly outstanding businesses that can often employ incremental capital to great advantage, either by putting it to work in their businesses or by repurchasing their shares. Obviously, every capital decision that our investees have made has not benefited us as shareholders, but overall we have garnered far more than a dollar of value for each dollar they have retained. We consequently regard look-through earnings as realistically portraying our yearly gain from operations."
Buffett believes that the intrinsic value of Berkshire Hathaway Inc. has grown at approximately the same rate as its look-through earnings in the past and will continue to do so in the future. Moreover, he believes this principle applies to any company. The idea is that all corporate profits benefit shareholders, whether they are paid out as cash dividends or invested back into the company. If an investor were to only regard the dividends he received from his shares as his return, he would ignore most of the funds—and the stock value—that was accruing to his benefit.
The look-through earnings concept, Buffett has said, forces investors to evaluate stocks for the long term. “We continue to make more money when snoring than when active,” he explained to investors in 1996. “Our look-through earnings have grown at a good clip over the years, and our stock price has risen correspondingly. Had those gains in earnings not materialized, there would have been little increase in Berkshire’s value.”
How Do You Calculate Look-Through Earnings?
Look-through earnings considers a company's total profit picture, including both dividends and retained earnings on a per-share basis. So, if a company's fully-diluted after-tax earnings was $3 per share, and it pays $1 per share annually to its shareholders as dividends, then $2 per share is retained earnings, and presumably reinvested into the company's growth.
How Can an Investor Use Look-Through Earnings?
An investor seeking capital appreciation in their investments should fine those stocks that feature the most look-through earnings. As a rule of thumb, value investors suggest that one should move out of one investment and into another if there will be at least 20-30% greater earnings potential in the new investment.
What Is Look-Through Analysis?
Look-through analysis takes an in-depth look at the holdings of a portfolio to not only gauge the portfolio's risks and diversification, but also to analyze where the cash flows come from among all of the holdings. This allows portfolio managers to better assess overall risk, as cash flows in different companies may come from very similar sources, creating similar risks. This type of analysis can also be used to better evaluate ESG portfolios to see how "green" the cash flows really are.