What are look-through earnings?
Warren Buffett pioneered the concept of look-through earnings as a way to accurately evaluate earnings associated with all of Berkshire Hathaway’s holdings - not just those that Berkshire fully or significantly owned.
Buffet’s view is that GAAP earnings are not adequate in telling the full story of Berkshire’s economic progress or intrinsic value. He feels this way because accounting rules dictate that Berkshire only report as earnings the dividends received from companies (such as Coca-Cola or American Express) that Berkshire invests in but does not control, even as those dividends represent only a small share of the earnings attributable to Berkshire’s ownership.
"We have found over time that the undistributed earnings of our investees, in aggregate, have been fully as beneficial to Berkshire Hathaway as if they had been distributed to us ... 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 ... We consequently regard look-through earnings as realistically portraying our yearly gain from operations." - Berkshire Hathaway Owners Manual
Key measures for an evaluation of look-through earnings fundamentals
As market prices fluctuate, it is easy to get distracted and influenced by the sentiment of the market. As we sought to inoculate ourselves against market volatility, Warren Buffett’s writings inspired us to create our first portfolio look-through earnings report. During the years since, we have found it essential to have this touchstone for monitoring the real business value on which the Fund has a claim.
In general, higher numbers for these measures are more attractive.
Earnings Yield Return on Capital Equity / Assets Revenue Growth
This measures how inexpensive a company is in relation to its demonstrated ability to generate cash for its owners. More >
This measures how well a company has historically generated cash for its owners in relation to how much capital has been invested (equity and long-term debt) into the business. More >
This measures how much of a company’s assets can be claimed by its common shareholders versus being claimed by others.
This shows the annualized rate that a company has grown across the past four years.
An analogy to understand look-through earnings
"The goal of each investor should be to create a portfolio (in effect, a "company") that will deliver him or her the highest possible look-through earnings..." - Berkshire Chairman's Letter, 1991
To understand what look-through earnings means in the context of a fund, think about the analogy of a business that has 30 divisions. At the end of each period, that business would consolidate the financial results of all 30 divisions into one set of financial statements. If you owned this diversified business, you would pay attention to the performance of each division and you would care greatly about how much cash you could pocket across all divisions each year. Your wealth would increase to the extent that your aggregate owner earnings stream increased at a rate exceeding inflation over the long-term.
Look-through earnings applied to investing
At Euclidean, we seek to own shares in approximately 50 companies. If a given portfolio company has $300M market value and we own $3M worth of its shares, then we own 1% of that business. So, to create our look-through financials, we take 1% of that business’s revenue, cash, debt, earnings and so on and combine that with our pro rata share of our other holdings’ financials.
These look-through earnings help us understand the same things that our fictional CEO with 30 divisions would care a lot about:
- How much annual, discretionary cash flow do we have?
- How does our balance sheet look? Is the business growing?
The answers to these questions matter because – to paraphrase Benjamin Graham – in the short-run, the market behaves like a voting machine but over the long-run, the market more closely resembles a weighing machine. Graham’s point is that fear, greed, and other emotions (the voting machine) can drive short-term market fluctuations that cause disconnects between the price and true value of companies’ shares. Over long periods of time, however, the weighing machine takes over as companies’ underlying business results ultimately cause the value and market price of their shares to converge.
Being in touch with our investments’ underlying business results keeps us grounded in what matters and helps protect us from being unduly influenced by the market’s many swings.